European real estate grapples with inflation, higher yields: assessing challenges for debt holders
By Florent Albert, Director, and Philipp Wass, Executive Director
Accelerating structural changes in Europe’s economy post-Covid will remodel the property sector after a decade of loose monetary policy and the huge fiscal response by governments to the pandemic. Higher capitalisation rates, uneven rental growth and the economically uncertain outlook will lead to the underperformance of some, but not all, real estate asset classes.
The cost of debt and equity are rising, resulting in negative leverage returns for the first time in many years. The cost of debt exceeds investment yields just as rising capex budgets, debt restructuring, refinancing of pandemic-related bridging finance are contributing to the sector’s growing funding needs.
Partially hedged borrowers face a limited increase in term risk, but refinancing risks are growing for all.
The outlook for different types of assets is nuanced in the current environment. Assets generating foreseeable cashflows and owned by landlords with strong pricing power to pass costs through will outperform.
Industrial and residential rental income will hold up best given the favourable supply-demand balance in both property segments and inflation-indexing of rents. In contrast, values of low-yielding assets are under pressure, particularly in second-tier locations and for stranded buildings whose owners face hefty bills for meeting tougher environment-related regulations.
In Europe’s commercial real estate sector, the worst may be over for retail property, but primary city locations, good catchment areas and business models resilient to competition from e-commerce will drive performance.
For investors holding development loans, increasing construction times, rising costs and uncertain gross developed value represent significant headwinds.
At least many of the larger real estate companies in Europe have stronger balance sheets than in the period before the global financial crisis, with low interest rates locked in for the medium term.
The salient features of the markets for CMBS and CRE loans are:
- Average 60% debt-leverage CRE loans need to decrease to 45%-50% LTV to adjust to the new rate environment or refinanced property values will have to fall by 20%-30% to restore ICR covenants to around 1.3x.
- We see no short- to medium-term CMBS refinancing wall – but first cracks are appearing in shopping centre and hospitality CMBS.
- Few CMBS have yields below current all-in rates.
Watch the recording of Scope’s recent webinar Rising inflation, higher yields: assessing the challenges for holders of European real estate debt, download the slide deck, and check out our newest methodologies:
Scope Ratings Structured Finance methodology: CRE loan and CMBS rating methodology
Scope Ratings Corporates Finance methodology: European Real Estate Rating Methodology