Since the GFC in 2008 a new breed of non-bank lenders has emerged while traditional banking institutions fell prey to heightened regulations in the light of Basel III forcing banks to a more cautious approach to real estate finance and markets. As a result of the reduced availability of traditional bank financing the global private debt market rapidly has been growing up to $595 billion in 2016 with further growth potential up to $2.5 trillion within the next ten years (according to Preqin). It’s safe to say, that Real Estate Private Debt evolved into a stand-alone asset class and into an attractive alternative to traditional fixed income products i.e. state treasury or corporate bonds.
One way to invest into real estate private debt is direct lending against all types of illiquid property asset classes of various types, including a) financing and refinancing of property acquisitions, b) financing of redevelopment of existing property, and c) new development finance. Typically, assets pooled in a special purpose vehicle (SPV) in a non-recourse financing structure limit borrower’s obligations towards interest and principal repayments to the underlying assets with no further collateral unless otherwise stipulated. On the other side, direct lenders are drawn by the prospect of predictable asset-backed cash-flows underpinned by protective cash-sweep and default covenants. Unlike with liquid corporate bonds which usually lack collateral, direct lenders own collateral which typically exceeds the value of the loan facility granted and are thus protected in a default scenario, granting them first rank status before all unsecured creditors. Being in a direct relationship, lenders and borrowers can individually customise and negotiate contract terms and covenants, with lenders getting control over the workout process in case of distressed situations. Within senior, junior or whole loan products (which may combine a senior syndicated tranche with a mezzanine or junior tranche), alternative lenders apply the same mortgages, notes, guarantee documents and investor protections like banks while being more flexible in the underwriting process and in the phrasing of covenants. Covenants would assess current asset valuation, vacancy levels and income during loan maturity term, and guarantee heightened lender control over the asset in case of a covenant breach.
Similar to traditional loans, and unless the loan agreement stipulates lock-out periods preventing the borrower from repaying the loan before maturity, borrowers can pay back the loan anytime with previously agreed upon prepayment penalties serving as a trade-off for lenders’ lost interest payments. With all that, and similar to Private Equity investments, the meticulous analysis of the underlying asset’s value, the asset performance, and the borrower’s credit and equity story, all are essential in the underwriting process.
Looking at the European landscape, the number of debt financed transactions is steadily growing. With the demand for European real estate still going strong in 2019, with foreign capital inflows continuing, and after 10 years of surging markets, Europe finds itself at the beginning of a refinancing cycle. As an estimated half trillion of debt will mature, steady opportunities for private lenders continue to rise, fueled by the growing trend in traditional bank financing to return to conservative LTV/LTC ratios, and banks’ reluctance to refinance certain asset classes.
Consequently direct lending at higher LTVs/LTCs, focussing on transitional assets and opportunistic strategies will be the tipping point for non-bank lenders to remain competitive in the future.