Mind the Extensions

• Real estate private debt growing 12.1% pa
• The BoE’s Q1 Credit Conditions survey of UK-based lenders cite improving conditions
• Fitch expect global CRE loans?to deteriorate through 2025
• Scope?data shows 40% of European CMBS loans face significant refinancing challenges
• CIO of PIMCO Real Estate says higher debt costs will create a 'tsunami' of refinancing requirements

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Private credit has become instrumental to capital markets, as it fills a void in lending to smaller companies which banks have less inclination to do. Despite concerns about its unregulated nature potentially leading to a bubble and systemic risk, data from Ares Management suggests that the private credit market is not as extensive as perceived. Their estimates suggest that total U.S. direct lending stands at $0.79tn, significantly less than the ￡2.7tn syndicated leveraged loans and high yield, or the $2.8tn of commercial and industrial bank loans. Rather than rampant expansion they also estimate that the growth in private debt AUM over the last 10 years (14.7%pa), has been very similar to private equity (14.2%pa) and not much more than real assets at (12.1%pa).

Moreover, Ares challenges the notion of private credit being unregulated, highlighting oversight from over 25 global regulatory agencies and that banks providing credit require comprehensive portfolio data, giving banking regulators insight into direct lending loans. Additionally, public filings by Business Development Companies (BDCs) reveal loan holdings and pricing. In terms of systematic risk, Ares also question the notion that direct lending implies more risk than traditional bank lending. Direct lending funds typically operate with 50% leverage, requiring a 50% loss rate before fund equity is affected, whereas banks often operate with 10:1 leverage ratios, meaning only a 9% loss rate is required before bank equity is lost.

In another note, Invesco outlines the relatively obvious case for real estate credit. Firstly, substantial interest rate hikes, following periods of historically low rates during the Global Financial Crisis and the COVID-19 pandemic, suggest that rates are unlikely to return to near-zero levels. This trend is expected to support higher yields on real estate debt in the future. Secondly, property values in key global markets have declined since early 2022 due to elevated interest rates and expectations of slowing economic growth. This decline presents an opportunity for new loans to be sized against below-peak collateral values, providing a cushion against further price declines. Thirdly,?post-GFC regulations have strengthened bank lending practices, leading to less aggressive pricing. Further regulatory tightening is expected in response to recent U.S. bank failures, potentially increasing costs for banks and limiting their lending activity. This could create opportunities for non-bank lenders as banks pull back, particularly in regions where bank lending accounts for a significant proportion of real estate loan volume.

KKR echo these points and highlight 2023 as a transitional period characterized by macroeconomic uncertainties, interest rate hikes, and property value declines; which subdued market activity. However, they foresee 2024 as a year ripe with transactional opportunities, particularly for well-capitalised lenders. The case for increased transaction activity in 2024 is underpinned by several factors. Firstly, with inflation on the decline, KKR believes that the downward trajectory of real estate values is nearing a nadir, potentially narrowing the gap between buyers and sellers. Additionally, rebounding prices of real estate equity REITs and tightening credit spreads signal a market recovery, while real estate private equity funds sit on substantial dry powder, poised for action. KKR also underscores the attractiveness of returns in the current market environment. Lending opportunities exist at significant discounts to replacement costs, offering the potential to earn equity-like returns at advantageous positions in the capital structure. Furthermore, they suggest that current valuations in real estate credit present an appealing proposition compared to other asset classes, promising attractive absolute and risk-adjusted returns.

The Bayes Commercial Real Estate Lending Report which came out last week documented the state of the UK lending market in 2023, revealing a significant decline in loan originations, down by 33% year-on-year. The decrease was particularly notable among international banks (-49%), debt funds (-50%), and German banks (-37%). Through 2023, German banks reduced their overall loan books by 17%. Whilst European banks overall faced challenges due to higher lending costs stemming from Basel IV and higher sterling funding costs, many German banks faced additional constraints related to Pfandbrief criteria, no longer encompassing UK property. Notably, larger lenders (with portfolios exceeding ￡5bn) exhibited a weighted average default rate of 1.5%, contrasting with smaller lenders (under ￡1bn) experiencing a significantly higher default rate of 7.5%.?

According to Fitch Ratings, credit trends in global CRE loans are expected to continue deteriorating through 2025. Despite this, most issuers are anticipated to stay within ratings expectations, given the diverse range of risks across the financial system. Floating-rate loans pose the highest credit risk, particularly as most CRE sectors have experienced declines in value over their typical maximum five-year term. Weaker issuers with higher concentrations of risky exposures may face downgrades as a result. Additionally, the retreat of lenders from office spaces will heighten refinancing risk, leading to increased workout activity and credit losses. Fitch Ratings forecasts that the overall U.S. CMBS delinquency rate will rise to 4.9% in 2025, up from 2.3% as of February. Alarmingly, three out of four U.S. conduit office loans maturing in 2024 are expected to default.

Analysis from Scope mirrors this assessment across the pond with almost 75% of CRE loans within European CMBS portfolios currently thought to fall short of meeting bank refinancing requirements. Their analysis suggests that 40% of fully-extended securitized loans are poised to face high or very high refinancing risks in 2024. Moreover, the category of loans facing moderate refinancing risk has significantly expanded from 23% to 41%. As borrowers continue to exercise loan-extension options, the anticipated €3.4bn refinancing wall for 2024 has been reduced to a slightly more manageable €2.6bn. However, despite these developments, it is projected that 40% of loans still face significant refinancing challenges.?

The BoE’s Q1 Credit Conditions survey of UK-based lenders also provided further evidence of improving conditions with the availability of debt increasing for the first time in six quarters. This improvement was picked up at the Moody's credit conference, the outlook for the CRE sector which was generally negative about Europe but with slightly less pessimism surrounding the UK. This distinction stemmed from the UK's quicker pace of adjustment compared to its European counterparts, reflecting the typical lag effect observed in CRE markets. Current market conditions were reported to have made it challenging to raise equity and execute property disposals. Despite these obstacles, instances of equity injections into the market were cited as indications of some ongoing investor interest in select opportunities, such as Qatar's notable ￡300 million investment into Canary Wharf.

As the market begins to thaw in 2024, TPG Angelo Gordon expects banks to opt for loan sales to manage their capital requirements. They see this as an opportunity for them to leverage their capital and real estate expertise to swiftly analyse and transact on distressed asset offerings. Bank failures, such as SVB and Signature Bank, intensified scrutiny on regional banks and their CRE allocations. FDIC data reveals that smaller banks, with assets below $10 billion, hold over 30% of their assets in CRE loans. Additionally, banks collectively hold 51% of all commercial mortgages, amounting to $2.9 trillion as of June 2023. Amidst low transaction volumes and a lack of price discovery, banks are motivated to offload problematic loans, especially considering the regulatory capital outlook.

Francois Trausch, the Chief Executive Officer and Chief Investment Officer of PIMCO Real Estate, in the PERE Network Europe Forum likened the drama in the CRE market to a Netflix series. He stated, "Right now, we are in the middle of season 2, which started well as the central banks in the US and Europe signalled the rate hiking cycle was over." Trausch emphasized that this clarity on debt costs has led to increased communication among stakeholders. However, he foresees trouble in forthcoming episodes, particularly highlighting the refinancing challenge as a key protagonist. "If rates stay where they are and do not come down as quickly as expected then of course, you are going to have another issue…which is the funding gap," Trausch explained. He predicted that the season finale will depict borrowers struggling "in large numbers" as higher debt costs create a 'tsunami' of refinancing requirements.

However, The Man Institute (part of the Man Group) see the maturity wall, which is commonly presented as a sword of Damocles, as an opportunity as well as a risk. They see the widespread pricing of refinancing risks in the high yield market as indiscriminate. Businesses with tangible assets, particularly in the real estate sector, possess the flexibility to sell, raise capital against, or dispose of these assets to manage their liquidity profile.

“Now that borrowing from the bank isn’t ‘free’ and isn’t easy [to secure], real estate does not have the shine it had before,” Rob Fleischman, a technology entrepreneur and investor,?who is chair of Tiger 21’s Boston group said. “Returns are compressed and risk is higher.?But being the lender to real estate folks is?better in this rate environment?and you get the property as collateral.” It’s only natural more participants entered the private real estate debt market. Similarly, if an economy can get through a recession, it sometimes tends to end up healthier wrote Bank of England economists. Economic crises usually ultimately lead to better companies that are more profitable. It's what the Austrian economist Joseph Schumpeter called ‘creative destruction.’ Bad businesses go bust; so-so businesses have to step up their act to survive; and good businesses tend to be OK. This usually means that resources that would have gone to bad businesses are freed up to serve good businesses, or to set up new ones. Capital was allocated to private debt vehicles and real estate debt funds were the beneficiaries of bad lending practices that occurred pre-GFC. Now that the economy is prima facie on a high and real estate valuations at a low, debt funds will have a more permanent place amongst the capital market ecosystem, but like the banks post-GFC, will need to be accommodating to borrowers for the foreseeable future.