By Florent Albert, Senior Director, Structured Finance

The public real estate fixed-income market is effectively shut and some privately funded borrowers are struggling to refinance. On the pure real estate financing side, there are myriad uncertainties relating to:

1. A selective liquidity crunch, particularly around secondary and non-ESG compliant assets;
2. Whether borrowers and lenders will co-operate as they did during the pandemic or if bank lenders will adopt a more rigid approach and foreclose;
3. How uneven property rental and value performance are likely to be and how the two interact in terms of valuation and underwriting by lenders;
4. How the stock of existing assets will be affected by a halt in construction activity, as current conditions have rendered it uneconomic to push ahead with projects;
5. Obsolescence risk, particularly in the office sector, as ESG factors have risen to the fore.

Opportunities for alternative lenders

European real estate has historically been funded by bank debt but non-bank alternative providers have increased market share since the global financial crisis, so questions remain about how real estate financing will evolve. Banks will typically support existing clients but they are retrenching from capital-intensive markets. On top of revised collateral values, capex needs for decarbonisation, and Basel III implementation in 2025, this will put additional pressure on the debt funding gap.

We expect this to create significant opportunities for alternative lenders, which will face lower competition while benefiting from a better risk-return lending profile because they will be financing assets at revised market values with lower leverage and more robust structures at higher spreads.

REIT share performance is good leading indicator of what could happen in the CMBS market and the non-mark-to-market bond market. Since 2020, REIT shares have fallen on average by 5% for industrial and 57% for multi-family but with a lot of dispersion. REITs are now trading at significant implied discounts to the appraised values of their assets and imply materially higher cap rates than what private markets are pricing in. But this is starting to seep into bond and CMBS markets.

Fewer downgrades but refi risk rises

There were massive CMBS downgrades by US-rating agencies during the pandemic, especially retail and hotel transactions. These were often unjustified in our view. There have been very few downgrades in the last year despite more bearish factors. We estimated in January 2023 that a third of commercial real estate loans in European CMBS face significant refinancing risk and noted in follow-up in March that refinancing risk was starting to crystallise through forced loan maturity extensions and defaults.

We had advocated as far back as December 2020, at the height of the pandemic, that lenders should focus on debt yield along with traditional metrics during the low-rate period rather than focusing exclusively on ICR for measuring refinancing risks.

Most CRE loans securitised since 2017 have had sound ICRs higher than 1.8x but debt yields in the mid-single digits. Consequently, many of them will exhibit weak ICRs in a 0.9x to 1.3x range in the current new rate environment with all-in rates at 6%-plus. These headwinds also affect the privately rated loan market where we have downgraded a few transactions, mainly in Germany, secured by under-construction or low-yielding secondary assets.

All of the loans that are of growing concern will either need an injection of equity or a rapid increase in cashflows to refinance. The latter is a hot topic with lenders questioning the pricing power of borrowers to pass on inflation in challenged property types (shopping centres, secondary office).

In the meantime, income growth has been strong for securitised loans secured by industrial assets, residential assets and, to a certain extent, mixed use. Hospitality assets were deeply impacted during the pandemic but have shown a significant rebound since then. The office sector exhibits the lowest average income performance after retail.

From a collateral valuation perspective, we believe further repricing will come for office mostly; and residential and industrial to a lesser extent while retail – with the exception of continental Europe shopping centres - has already mostly repriced.

Downbeat outlook

There is more pain to come. We expect more dispersion in the performance of real estate assets, while ESG prime assets exposed to favourable structural tailwinds and limited supply will perform much better than secondary stranded assets. This is already evident in vacancy rates and increases in rent-free periods.

We expect refinancing and forced maturity extensions to remain elevated in the next 18 months. This is driven by four main conditions:

1. Financing conditions have significantly changed; not so much in terms of spread but because benchmark yields have doubled and hedging is very costly. We expect advance rates to be capped by asset yields rather than by leverage levels.
2. Cautious underwriting. The market has shifted from borrower-friendly financing conditions to a lender-friendly world. Lenders can select between projects. With mezzanine lenders moving to the senior space and equity buyers moving to mezzanine, lenders have more power over borrowers and senior lending has become scarce.
3. Lack of liquidity in the secondary market and for assets exposed to obsolescence risk. For example, some Italian CMBS backed by shopping centres and retail with debt yields above 10% have been unable to refinance recently.
4. Over-valued assets: the value of an asset is the price that someone is prepared to pay. If there is no liquidity, derived or reset values may not represent final values. We expect further devaluations in sectors showing little to no trading activity.

On a positive note, we expect the securitisation real estate market to slowly reopen in the second half of 2023 with either granular CRE ABS or traditional CMBS cautiously structured and secured by assets with a positive outlook (industrial, data centres). This may be followed by a second attempt at CRE CLOs in the European real estate securitisation landscape.

Click here to view accompanying charts.

Related CMBS research

Webinar – European real estate: prepare for more pain from high yields; June 2023

European CMBS under pressure as refinancing risk intensifies concerns; March 2023

A third of commercial real estate loans in European CMBS face significant refinancing risk; January 2023

A primer on European CRE CLOs Same foundations as US CRE CLOs. Same success?; April 2022

European CMBS: Part 2 – wave of credit downgrades; tighter 2021 issuance; June 2021

Investors should assess debt yield alongside traditional financial covenants to capture CRE risk; December 2020

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