| The headquarters of the Bank of International Settlements (BIS) in Switzerland, the meeting place of the Basel Committee on Banking Supervision. |
Europe’s debt funding gap has paved the way for new, innovative structures that allow alternative sources of capital to flourish, such as mezzanine funds, although these are unlikely to plug the hole entirely.
In response to a debt funding shortfall in Europe caused by a retraction of traditional bank lending since the credit crisis, new financial models have emerged. New entrants like mezzanine debt funds and insurance companies are trying to exploit that gap, while European banks are once again starting to explore the concept of churning their balance sheets through the issue of commercial mortgage–backed securities (CMBS).
German “pfandbrief” lenders remain a dominant source of funding in Europe, thanks to their access to a German banking system that has roots reaching back to the 18th century. Considered a safe, if old-fashioned, debt instrument, pfandbrief is a type of covered bond issued by German banks.
Mortgage cover assets totaling €250 billion ($352 billion) stood outstanding as of March 2010, according to the German Mortgage Association. What is more impressive, is the fact that no issue has ever defaulted in the 200 years of pfandbrief’s existence.
The robust nature of the pfandbrief market helped the specialist German lenders ride out the financial storm and continues to be the mainstay of lending to European real estate. However, pfandbrief issuers face increased pressure from the requirements of pending banking regulation.
Basel III, agreed to by the members of the Basel Committee on Banking Supervision in response to the financial crisis, proposes new regulatory standards for banks to be phased in from 2013 to 2019 that will force them to hold more—and higher-quality—capital on their books than is required under current Basel II rules.
As a result, the cost of capital will soar, and the availability of debt could decline significantly. Basel III will apply to banks across Europe, but German pfandbrief lenders could feel more penalized than others because the type of low risk–weighted assets pfandbrief lenders invest in—public sector loans—face the same leverage limit as riskier assets. Therefore, pfandbrief banks would be treated in the same way as other lenders that do not play it as safe.
With new regulations to navigate as well as legacy books to manage, banks are still cautious, and the provision of senior debt remains limited. The refinancing bulge is also looming, while government demands on those financial institutions that received state support have combined to tighten the debt markets further.
This situation has created an opening for mezzanine providers to generate returns in the mid- to high teens (typically 12 to 15 percent) by offering a slice of capital that sits between senior debt and equity—an opportunity that has attracted the interest of a growing number of players. For example, the Blackstone Group, a private equity business, is targeting mezzanine deals through a subfund of its closed-ended Special Situations Fund II, focused on Europe.
One of the first outfits to break ground in this space was Pramerica Real Estate Investors, the real estate investment and advisory subsidiary of Prudential Financial in the United States. Having raised £150 million ($244 million) from six Prudential-managed accounts as well as a contribution from Dutch pension funds manager APG in June 2010, it provided mezzanine finance for U.K. private equity group Evans Randall’s £242.5 million ($394 million) purchase of Drapers Gardens in the City of London. This accompanied senior debt from German lender Eurohypo.
The transaction offers an indication of the important role mezzanine strategies will play in the future, Andrew Macland, managing director of Pramerica Real Estate Investors, said at the time of the deal last August. “Drapers Gardens is a significant benchmark of postcrisis funding for real estate and demonstrates the success that can be achieved through the collaboration of debt funds with sponsors and senior lenders in a capital-constrained market,” he said.
Yet there is little other hard evidence of deals that have been structured with mezzanine finance, partly because borrowers still see it as being too expensive. The scarcity of senior lending also makes it difficult for the funds to deploy capital.
| Drapers Gardens in the City of London was purchased by U.K. private equity group Evans Randall with mezzanine finance. |
One of the challenges Europe faces related to its debt shortfall involves the lack of diversity in funding. Unlike the United States, where lending is typically split between banking institutions and other lenders, including life insurance companies and CMBS, about 75 percent of the European market is dominated by banks. But insurance companies are becoming a new source of potential funding for real estate there, driven by Solvency II regulation. Likely to be implemented at the end of 2012, Solvency II will require European insurance companies to put aside extra capital for certain investments, which will encourage them to undertake property lending as a more efficient use of capital than investing in direct property assets.
AXA Real Estate Investment Management (REIM), the property management arm of the French global insurance group, has raised more than €350 million ($493 million) from AXA and other European insurance companies for a senior debt fund. Its strategy is to commit up to €1.5 billion ($2.1 billion) for commercial real estate debt.
“It is the right time for insurance companies to enter this space, because it provides diversification benefits,” says Isabelle Scemama, AXA REIM’s head of debt. Insurance companies are expected to stay at the lower end of the risk spectrum though, and it is unlikely that institutional capital will be sufficient to fill the shortfall.
Another financial model under review in Europe is CMBS, although the consensus is that it will come back from its collapse in a different form, if it does return. It would have to be a single-borrower deal backed by a single asset with predictable cash flows, for example, in order to generate investor appetite. Transparency would play a key role in shaping the new mold.
Exploration by Germany’s Deutsche Bank of a securitization of the £300 million ($487 million) senior loan it has agreed to provide Blackstone for its purchase of a prime business park called Chiswick Park in West London, U.K., is seen as a beacon for new European CMBS, if the deal goes ahead. It would be the first transaction of its kind since the market collapsed in the current recession. In addition, certain other European banks are focusing on hiring for their securitization teams, implying that there is confidence the market will mirror that of the United States in staging a revival.
In a tougher regulatory environment where bank lending remains selective, the idea of a return to the days of capital churning through CMBS may seem ambitious, but it could help alleviate the shortage of big-ticket loans. Meanwhile, the well-established pfandbrief model should trundle on.
The debt funding gap has paved the way for new, innovative structures that allow alternative sources of capital to flourish, such as mezzanine funds, although these are unlikely to plug the hole entirely. The single most important requirement for the European real estate markets is a return to health for the banking sector. And not even the banks themselves know how far off this could be.
