European real estate debt on an upward path

Ever since the Global Financial Crisis, ‘alternative’ lenders’ share of European real estate debt has risen relative to that of banks. This trend, which mirrored developments in the US a decade earlier, shows no signs of slowing down. Indeed, a recent look at the INREV Debt Vehicles Universe not only reveals that these funds have reached their greatest extent yet – 98 vehicles with a target equity totalling €60.3billion – but also that this figure has doubled over the last seven years. And over the last three years, ten newly launched vehicles have been added with a combined target equity of €6.78 billion, equating to 11.2% of the overall Universe. 

The growing importance of debt funds to real estate has also been highlighted by a 2022 report from Bayes Business School in the UK, which shows that alternative lending sources have now eclipsed both banks and building societies as sources of finance, contributing 38% of total lending. The UK has the most developed debt fund sector in Europe, reflecting the scale of its underlying investment market, which also supports the largest number of country-focused debt funds in the INREV Universe. 

However, it will not be lost on most observers that the period of debt funds’ rise has also been one of an extended – if gradual – boom in real estate values, and one which now looks set to come to an abrupt end, given the economic and financial upheaval facing the continent. With interest rates rapidly escalating to combat inflationary pressures and property values starting to fall, the climate for lenders looks very different. What will this mean for debt funds going forward? 

The first thing to say is that in general large-scale lenders to European real estate – whether banks or alternative sources – do not appear to be threatened by a potential market adjustment in the same way that they were before the GFC, as overall loan-to-value ratios are significantly lower. 

And the debt funds included in the INREV database are generally diversified across European markets, with multi-country vehicles making up more than 70% of target equity and dominating new fund launches: Eight of the 10 vehicles launched in the last three years follow a multi country, multi sector strategy. The newer funds are also relatively large in size, their average target equity of €680m exceeding the INREV Universe average of €650m. These characteristics should mean that the funds’ risks are relatively widely spread across markets and individual assets. 

Moreover, even if funds do see significant write-downs on their underlying assets, the closed end structure of most (over 85% of target equity) implies that they should not be faced by liquidity problems prior to the termination date. Indeed, the number of closed end vehicles has risen sharply in recent years, from 37 in 2016 to 80 in 2022. Such considerations are currently being reflected in proposed revisions to AIFMD, which state that a debt fund originating more than 60% of its net asset value in loans must have a closed end structure. 

However, refinancing debt vehicles post-termination may prove more challenging, even if 60 of the 80 closed end vehicles in the Universe have a provision to extend their termination date. In particular, investors in debt funds from the insurance and pensions sectors will be faced with a wider array of choices among safe higher yielding assets – most obviously government and corporate bonds. Much is likely to depend on the level real estate values have reached at termination, and whether there is still perceived to be more market pain to come. 

Whatever the underlying market conditions facing debt funds in the next few years, another key question will be whether they can provide a channel for funding retrofits for the purpose of decarbonising real estate assets. This has not proved to be a specific focus so far, but with banks’ reporting and regulatory frameworks tending to discourage such activity, this should potentially be an area of opportunity for debt funds, due to their relative lack of regulation. If such funds – and just as importantly, the investors behind them – are willing to take on this relatively new area of activity, then the rewards could be substantial. 

How well this will fit with debt funds’ position towards the lower end of the lending risk spectrum remains an open question. At present, those holding senior debt make up the lion’s share of the INREV Universe with 54 of the 98 vehicles. But their relatively flexible approach to loan generation strategies – with a combination of loan acquisition and direct lending tending to predominate – should help debt funds to evolve in the light of changing market conditions and real estate requirements.