Macroeconomics and Rising Finance: What Are the Latest Trends and Strategies?

While at MIPIM, I joined a panel of industry experts to discuss raising finance in a world of rising or higher interest rates.

Background

Real estate capital markets around the world have been in flux amid high inflation, raised interest rates, and falling values in certain sectors such as offices. These changes are challenging the viability of new schemes, creating obstacles around refinancing of existing assets and creating greater risk of distress and obsolescence among secondary and tertiary assets.

The big question will be the trajectory of inflation and when, exactly, interest rates will start to fall.

Opportunistic lenders remain fickle, resulting in a flight to quality, with living and logistics assets in favor as they offer inflation-beating rent increases. In contrast, confidence in the office sector is limited except for prime assets.

Against this evolving macroeconomic and real estate market milieu, lenders are increasingly focusing on strategic asset management, taking on a much more hands-on approach and insisting on robust business plans – sometimes working in a partnership more closely resembling those typically found on the equity side of the financing market.

Inflation, Interest Rates and Their Impact on the Market

So, what is shaping the market? Are we seeing a permanent shift in lenders’ appetites – both for types of assets and ways of working – or is it a sign of the times that will, itself, see a course correction much like the real estate market as a whole?

• Inflation - In the U.S., stubborn housing and rental costs have halted inflation reduction, although wages and service sector inflation have been trending down. In the UK, the battle against inflation has been more difficult due to political changes; banks have been extending loan facilities while hoping interest rates will come back down.
• Interest Rates – In Europe, interest rates are expected to reduce by the end of 2024, with markets forecasting early reductions, which will be key to when investment volumes pick up in the future. With past hikes in interest rates, financing costs have increased by around 300 bps, loan-to-value ratios (LTVs) have reduced, and debt margins have remained stable.
• Equity - Distress on equity will be coming through, although banks will likely prolong the inevitable. The global financial crisis (GFC) was different because interest rates fell off a cliff; this time, if a sponsor is unable to put in more equity, there will be an intervention.
• Flight to Quality – Whilst some offices are in a difficult position, grade A assets in the right location remain attractive to lenders. Central London office vacancy is sub 5% for grade A offices, and the same lenders caught up in issues with offices in the U.S. are quoting aggressively on grade A offices in Europe, showing lenders are not writing off sectors as a whole.
• Loan Extensions – Of the $10 billion of loans that matured in 2023, $9bn were extended, with banks stuck in the position that if they enforced on the loan, they would never get their money back. Banks realize that the sponsor is the best person to extract value from the asset. It’s not the ‘extend and pretend’ of the GFC, but rather ‘extend and do a lot of work.’

If you look beyond the headline numbers, there’s a lot more nuance there than might initially appear. Lenders, and the industry as a whole, have learned the lessons of the GFC and are working much more collaboratively to ensure that where things can work, they do work.

Is There Enough Debt Available?

In the U.S., around $1.3 trillion of debt is coming up for refinancing, much of which could be troubled. This will have a knock-on effect in terms of willingness to fund. The question is how big the funding gap will be between what sponsors need and what lenders might be willing to provide.

Potentially, there are enough lenders to fill the gap, but they are all chasing Class A/tier-one assets, creating a problem for the refinancing of second and third-tier assets. Refinancing is taking place in an evolving regulatory environment, with banks holding higher capital requirements against loan provisions. Alternative lenders, chiefly debt funds, will step in to make up the difference.

Many investors want to move from equity investment into debt investment. But although there’s lots of new money coming to the table, they have unrealistic expectations of the returns they can achieve. The times when 15%-20% returns were achievable are now over.

How Will the Debt Gap Play Out in the Market?

A challenge for some investors and an opportunity for others is where loans will be underwater and there will be forced sales. Mezzanine loan books are going at huge discounts as values have rebased, presenting an opportunity for investors.

• In Europe – the European Central Bank (ECB) is requiring banks to adequately provide against real estate loans at risk of default. The loan risk differs from country to country within the EU, with Germany and France presenting both the most risk and opportunities, due to high LTV lending.
• In the U.S. –  
  • Vendors have been accepting valuations considerably lower than they might have seen just a few years ago, but when the best offers come in and they are significantly below that, many find it difficult to stomach.
  • Against this background, cash buyers can buy at a discount with opportunistic investors eating up certain assets that were considered too pricey not that long ago.
  • Some lenders have adopted a counter-cyclical strategy with retail in investors' crosshairs over the last 12 months. Grocery-anchored retail and ‘necessity retail’ are becoming increasingly popular in the U.S., with lenders underweight in this sector and overweight in offices.

What’s Next?

Real estate debt has risen over the past year amid greater challenges in equity financing. It is increasingly clear that investors and developers will need to holistically understand the opportunities of debt if they want to make an impact in markets across the U.S. and Europe in the months and years to come.