Article
Navigating Scarce Liquidity in Europe
November 1, 2023 5 Minute Read Time
Liquidity in European real estate markets has been scarce over the past year. Lending capacity for refinancings, new loans and restructurings has dwindled, leading to selectiveness, lower LTVs and higher margins. The causes are interrelated, while the impacts across real estate markets and between investors has been uneven.
In this article, we will outline the macroeconomic context, explore the impacts for borrowers across sectors in Europe, share insights on how CBRE Investment Management (CBRE IM) has successfully navigated financing markets and demonstrate how this environment presents compelling value-add plays. In periods of scarce liquidity, opportunities are hidden beneath the surface.
Interest rates rose much faster and higher globally than investors forecast, triggering a divergence in asset valuations between public and private markets. This phenomenon, known as the “denominator effect,” forced investors and banks to decrease exposure to real estate due to falling valuations in other asset classes. Equity investors have chosen to wait out the uncertainty, slowing down deal flow. While this issue has subsided since its peak in Q2 2022, it remains a concern. Reduced liquidity in the equity market has compounded the scarcity in financing markets, with routine loan pre- or re-payments from asset disposals dwindling, limiting banks' ability to support (re-)financings needs for new clients.
Rising interest rates and market volatility also create underwriting challenges and affect debt capital markets (DCM) as investors demand higher yields for bonds, leading to higher borrowing costs for issuers. Uncertainty over the trajectory of interest rates has led to paused or cancelled transactions. While interest rates have seemed to peak and liquidity is slowly returning, there remains an additional risk premium in spreads for the real estate sector. Furthermore, the syndication market remains illiquid, with banks only underwriting loans they can retain on their balance sheets, reducing liquidity for large transactions.
Overall, scarce liquidity has eroded market sentiment for European real estate investments, extensive risk assessments and prolonged transaction timelines.
In Europe, we have observed significant disparities in the cost of debt between EU and non-EU countries, but also within the eurozone. Loans with LTVs below 35% are considered the lowest risk category to banks, but we have not seen any price benefit for lower LTVs. Debt remains non-accretive at current yields for core assets. Lenders anticipate yields will need to move higher implying margins may become even more expensive in the short term before reversing.
Banks are actively reducing loan portfolios and renegotiating loans to reduce risk. Requests include increased amortization to decrease LTVs and stricter financial governance. The loan approval process now takes about 50% longer than a few years ago due to enhanced credit analysis and due diligence processes. Loan size and pricing are now determined by interest cover ratios (ICR) rather than LTV, with additional considerations given to asset specifics, amongst others location, sector, leasing profile, and importantly sustainability credentials.
Preferred loan sizes are typically between €25 million and €80 million, due to the inactive syndication market limiting large deals. As profitability has increased importance, there is less interest for smaller transactions. Sustainability credentials are vital. Banks are unwilling to finance non-sustainability compliant properties, without a brown-to-green business plan. The European Central Bank (ECB) now mandates additional reporting requirements, with banks redirecting the additional reporting workload directly onto borrowers. Also, we have noted a difference in sustainability adoption among banks, with Dutch and French banks leading the way, followed by the slightly slower German Pfandbrief banks, while U.S. banks lag behind.
Bank-favored sectors include income-producing residential, logistics, student accommodation and care homes. Development financing is rare, with many projects facing delays, reduced equity availability and hesitant buyers. Inflationary pressures on labor and construction costs have added to lenders’ caution. Retail is a mixed bag, with banks showing more positivity towards performing income-producing retail properties more recently. In our experience, local lenders tend to look more favorably on the retail sector. The office sector is highly bifurcated with well-trailed troubles in U.S. legacy (non-sustainable) markets providing evidence that the sector is battling longer-term structural headwinds.
At CBRE IM, debt is not simply a tool to boost returns; it is also considered a part of the balance sheet. All our open-ended vehicles have revolving credit facilities (RCFs) that provide liquidity to seize opportunities in today's market. While this comes with higher costs and margins, it ensures vital liquidity, enabling us to opportunistically capitalize on market dislocations. When launching new vehicles, we structure them with fund-level debt secured by subscription equity from LPs, which also provides flexibility to deploy balance sheet capacity rapidly.
Across our EMEA direct strategies, CBRE IM successfully arranged €3.9 billion of debt in 2022 and approximately €1 billion in 2023 to date. These deals include refinancings, loan extensions and new debt, all arranged by our in-house finance platform. Across our €10 billion EMEA loan book, approximately 87% is hedged, and the remainder is floating by design. Our strong banking relationships and sustainability alignment have been instrumental in securing financing in this market. In July, we closed a €275 million unsecured term loan facility for our pan-european logistics strategy with three banks. The Facility is provided by a syndicate of three banks acting as Mandated Lead Arrangers and consisting of ABN AMRO Bank (ABN AMRO), Crédit Agricole CIB (CACIB) and ING Bank (ING), all three of which are trusted banking partners of the strategy. The new facility is structured to become sustainability linked in the course of 2023 and will be used to refinance maturing debt and finance new acquisitions, allowing the strategy to grow further.
On the flip side, occupancy has remained resilient. While capital values have fallen, rents for prime assets have risen across the favored sectors. This presents a compelling dynamic for value-add investing, where the aim is to create value at the asset level, requiring strong occupancies. In the current environment, this is possible at discounted entry levels. For example, the illiquidity in development markets has allowed CBRE IM to explore site acquisitions that would otherwise be unavailable at rebased prices. Managers with long-term capital, like CBRE IM, can look beyond current poor sentiment for development and seize this window of opportunity.
Despite financial turbulence, for those able to navigate the illiquidity challenge, the market offers compelling opportunities for world-class value-add investors. This may mean, for example, evaluating potential office-led refurbishments in London on an unlevered basis due to the scarcity of debt capital for this market segment. Pricing in some cases is below replacement costs reflecting heightened risk and significant capex requirements to achieve full occupancy and rent reversion.
The market environment has created a confluence of challenges, but the strength of CBRE IM’s platform, our lender relationships, global and our local market presence has successfully mitigated them. These strengths have allowed CBRE IM to seize pockets of liquidity and capitalize on broader market stress finding attractive value-add opportunities. This environment is expected to continue for the remainder of 2023 and into next year and possibly even 2025 presenting an extended window of opportunity to cherry-pick value-add investments, navigate low liquidity and deploy capital at attractive entry prices.
In this article, we will outline the macroeconomic context, explore the impacts for borrowers across sectors in Europe, share insights on how CBRE Investment Management (CBRE IM) has successfully navigated financing markets and demonstrate how this environment presents compelling value-add plays. In periods of scarce liquidity, opportunities are hidden beneath the surface.
Macroeconomic context
Over the last 12 months, central banks have unwound liquidity programs established during the global financial crisis and the pandemic. Simultaneously, they have tightened monetary policies. EU regulatory changes have also increased, demanding banks maintain higher equity reserves on their balance sheets for real estate loans. These factors collectively reduce the lending capacity and motivation of banks for real estate financing.Interest rates rose much faster and higher globally than investors forecast, triggering a divergence in asset valuations between public and private markets. This phenomenon, known as the “denominator effect,” forced investors and banks to decrease exposure to real estate due to falling valuations in other asset classes. Equity investors have chosen to wait out the uncertainty, slowing down deal flow. While this issue has subsided since its peak in Q2 2022, it remains a concern. Reduced liquidity in the equity market has compounded the scarcity in financing markets, with routine loan pre- or re-payments from asset disposals dwindling, limiting banks' ability to support (re-)financings needs for new clients.
Rising interest rates and market volatility also create underwriting challenges and affect debt capital markets (DCM) as investors demand higher yields for bonds, leading to higher borrowing costs for issuers. Uncertainty over the trajectory of interest rates has led to paused or cancelled transactions. While interest rates have seemed to peak and liquidity is slowly returning, there remains an additional risk premium in spreads for the real estate sector. Furthermore, the syndication market remains illiquid, with banks only underwriting loans they can retain on their balance sheets, reducing liquidity for large transactions.
Overall, scarce liquidity has eroded market sentiment for European real estate investments, extensive risk assessments and prolonged transaction timelines.
Impact on real estate borrowers
Scarce liquidity has made banks more selective about who they lend to and increases the cost of the debt they provide. The rise in margins reflects an increased perception of risk in real estate lending, higher funding costs, supply and demand dynamics and new EU regulations. Lenders’ selectiveness is primarily a liquidity issue, not a pricing one, with risk being a secondary consideration.In Europe, we have observed significant disparities in the cost of debt between EU and non-EU countries, but also within the eurozone. Loans with LTVs below 35% are considered the lowest risk category to banks, but we have not seen any price benefit for lower LTVs. Debt remains non-accretive at current yields for core assets. Lenders anticipate yields will need to move higher implying margins may become even more expensive in the short term before reversing.
Banks are actively reducing loan portfolios and renegotiating loans to reduce risk. Requests include increased amortization to decrease LTVs and stricter financial governance. The loan approval process now takes about 50% longer than a few years ago due to enhanced credit analysis and due diligence processes. Loan size and pricing are now determined by interest cover ratios (ICR) rather than LTV, with additional considerations given to asset specifics, amongst others location, sector, leasing profile, and importantly sustainability credentials.
Preferred loan sizes are typically between €25 million and €80 million, due to the inactive syndication market limiting large deals. As profitability has increased importance, there is less interest for smaller transactions. Sustainability credentials are vital. Banks are unwilling to finance non-sustainability compliant properties, without a brown-to-green business plan. The European Central Bank (ECB) now mandates additional reporting requirements, with banks redirecting the additional reporting workload directly onto borrowers. Also, we have noted a difference in sustainability adoption among banks, with Dutch and French banks leading the way, followed by the slightly slower German Pfandbrief banks, while U.S. banks lag behind.
Bank-favored sectors include income-producing residential, logistics, student accommodation and care homes. Development financing is rare, with many projects facing delays, reduced equity availability and hesitant buyers. Inflationary pressures on labor and construction costs have added to lenders’ caution. Retail is a mixed bag, with banks showing more positivity towards performing income-producing retail properties more recently. In our experience, local lenders tend to look more favorably on the retail sector. The office sector is highly bifurcated with well-trailed troubles in U.S. legacy (non-sustainable) markets providing evidence that the sector is battling longer-term structural headwinds.
Resilience amid illiquidity
The financing market across Europe have presented many challenges, but not all investors have felt the impact equally. For sponsors like CBRE IM, with a strong local market presence, extensive investment and operational capabilities, a track record spanning multiple sectors, local and global asset management pedigree, market-leading sustainability credentials and deep transaction and finance teams, liquidity remains accessible.At CBRE IM, debt is not simply a tool to boost returns; it is also considered a part of the balance sheet. All our open-ended vehicles have revolving credit facilities (RCFs) that provide liquidity to seize opportunities in today's market. While this comes with higher costs and margins, it ensures vital liquidity, enabling us to opportunistically capitalize on market dislocations. When launching new vehicles, we structure them with fund-level debt secured by subscription equity from LPs, which also provides flexibility to deploy balance sheet capacity rapidly.
Across our EMEA direct strategies, CBRE IM successfully arranged €3.9 billion of debt in 2022 and approximately €1 billion in 2023 to date. These deals include refinancings, loan extensions and new debt, all arranged by our in-house finance platform. Across our €10 billion EMEA loan book, approximately 87% is hedged, and the remainder is floating by design. Our strong banking relationships and sustainability alignment have been instrumental in securing financing in this market. In July, we closed a €275 million unsecured term loan facility for our pan-european logistics strategy with three banks. The Facility is provided by a syndicate of three banks acting as Mandated Lead Arrangers and consisting of ABN AMRO Bank (ABN AMRO), Crédit Agricole CIB (CACIB) and ING Bank (ING), all three of which are trusted banking partners of the strategy. The new facility is structured to become sustainability linked in the course of 2023 and will be used to refinance maturing debt and finance new acquisitions, allowing the strategy to grow further.
Capitalizing on illiquidity and dislocation
The current environment lends itself to a value-add approach. Distress and stress in the market have caused capital values to adjust significantly, creating attractive entry points. Additionally, listed vehicles are unable to refinance present opportunities through secondaries’ execution.On the flip side, occupancy has remained resilient. While capital values have fallen, rents for prime assets have risen across the favored sectors. This presents a compelling dynamic for value-add investing, where the aim is to create value at the asset level, requiring strong occupancies. In the current environment, this is possible at discounted entry levels. For example, the illiquidity in development markets has allowed CBRE IM to explore site acquisitions that would otherwise be unavailable at rebased prices. Managers with long-term capital, like CBRE IM, can look beyond current poor sentiment for development and seize this window of opportunity.
Despite financial turbulence, for those able to navigate the illiquidity challenge, the market offers compelling opportunities for world-class value-add investors. This may mean, for example, evaluating potential office-led refurbishments in London on an unlevered basis due to the scarcity of debt capital for this market segment. Pricing in some cases is below replacement costs reflecting heightened risk and significant capex requirements to achieve full occupancy and rent reversion.
The market environment has created a confluence of challenges, but the strength of CBRE IM’s platform, our lender relationships, global and our local market presence has successfully mitigated them. These strengths have allowed CBRE IM to seize pockets of liquidity and capitalize on broader market stress finding attractive value-add opportunities. This environment is expected to continue for the remainder of 2023 and into next year and possibly even 2025 presenting an extended window of opportunity to cherry-pick value-add investments, navigate low liquidity and deploy capital at attractive entry prices.