Rents, rates and the refinancing gap

Read this article to understand:

• Why we expect an uptick in transaction volumes this year
• The structural shifts occurring in commercial real estate
• Where liquidity pressures are being felt most keenly

Real estate investors faced significant challenges in 2023, as rampant inflation, higher borrowing costs, sluggish growth and ongoing structural shifts combined to create uncertainty in many sectors.

It should come as no surprise, then, that the number of European commercial real estate deals tumbled, hitting a low not seen in over a decade, as investors grappled with falling property values.

In real estate debt markets, lenders started to introduce more stringent lending criteria and borrowers faced higher costs for servicing their debt. This could create ongoing challenges: CBRE has highlighted the possibility of a “debt funding gap” of €176 billion as commercial property borrowers struggle to refinance loans reaching maturity between 2024 and 2027.¹

But along with risks come opportunities. From an investment standpoint, current valuations could represent an attractive entry point, according to Gregor Bamert, head of real estate debt at Aviva Investors. In this Q&A, Bamert also discusses the outlook for offices and why lenders should pay attention to non-traditional metrics to navigate risks in the current environment.

How would you summarise commercial real estate debt activity in 2023, and how do you expect transaction volumes this year to compare? Is investment picking up?

The commercial real estate debt market experienced significantly lower activity levels in 2023, compared to both the previous year and the five-year average.

This was driven by two factors. One was underlying transaction volumes. The buying and selling of real estate were down between 40 per cent and 50 per cent in the UK. Second, there was an even bigger decrease in refinancing activity, with borrowers more cautious because of macroeconomic and political uncertainties. This became a self-fulfilling prophecy: with fewer deals on the table, valuations became more uncertain, leading to further hesitancy in deploying capital, leading to even lower volumes.

However, as we move forward, the range of likely outcomes on key economic variables is narrowing, and that is giving investors a degree of confidence. Additionally, there has been a significant value adjustment in the market already, giving a good entry point.

On a risk-adjusted basis, the relative value of debt investments looks favourable compared with real estate equity (see Figure 2). As a result, we are seeing a significant increase in debt activity at the start of this year compared to last year, and we expect a meaningful uptick in transaction volumes in 2024.

In which areas are liquidity pressures most pronounced?

There are still liquidity pressures in many areas. Analysts often refer to the “refinancing gap” or “debt gap” to describe a scenario where there is less debt available than borrowers need to refinance, which leads to liquidity issues.

There are three main drivers of these pressures. One is in situations where there is a need for significant investment to improve a building. Often, these are assets which are not where they need to be from a sustainability perspective, and where borrowers are struggling to raise the necessary level of financing.

Two is structural shifts. We have seen a meaningful reduction in property values – a peak-to-trough capital value decline of 25 per cent in the UK – in response to rising rates and the economic slowdown. But while this cyclical impact is clear, what we haven’t seen come through fully yet is the more structural impact of the changes in the way offices, in particular, are used. For example, we expect secondary offices to see continued declines in value. This contributes to liquidity challenges, as there will be less interest from equity investors in these properties and fewer lenders willing to engage.

Three, concerns over lease terms and tenant viability. Situations where short-term tenants who face challenges are unable to pay their rents create questions regarding the stability of rental incomes and this makes certain parts of the market less appealing to lenders, further intensifying liquidity pressures.

With rate cuts expected this year, what is your outlook across sectors? Which sectors will benefit and where do you expect to see further challenges?

We see strong fundamentals in living sector – encompassing single-family and multi-family homes, as well as student accommodation. Industrials, urban warehouses and life-sciences facilities should benefit from longer-term structural changes and there should therefore be greater tolerance for debt servicing costs in these sectors.³

Prime office spaces are experiencing some rental growth and we expect more of that going forward. These are offices that remain attractive to businesses, because of their quality and amenities. In contrast, offices that fail to meet these criteria, due to a less-accessible location or other disadvantages, will continue to see declining rents and values. This isn't just a market reset but a continuing divergence, signalling a deeper shift in the real estate landscape in the wake of changes such as the rise in remote working following the COVID-19 pandemic. The result is likely to be a “K”-shaped recovery in the market.

On that point, we have seen distressed sales of large office buildings in locations such as the Canary Wharf district of London.⁴ What does this tell us about the state of the market?

Some of the London office properties that have recently been sold as part of an enforcement process were built in a period when sustainability was less of a priority and large floor plates were designed to cater to investment banking-style operations. In many cases there has been only minimal refurbishment to these properties over the years, so buildings that might have been kept relevant with some care and attention have become less attractive to occupiers.

The lesson is clear: simply purchasing a property and waiting for its value to go up is a flawed strategy. The key to success in the current real estate landscape is active engagement in making properties more relevant and appealing to tenants.

A good example is Henrietta House, the European headquarters of CBRE near Oxford Street, which is a building whose refurbishment we financed as part of a collaborative effort between landlord and tenant focused on creating an office that employees really want to go to and spend time in.

Which metrics should lenders pay particular attention to as they look to manage risks in what remains an uncertain environment?

To properly gauge and navigate risks, lenders require an approach that goes beyond traditional metrics. For example, lenders have traditionally looked at the ratio of the loan to the value of the asset as a key measure of risk. But whether the loan-to-value (LTV) is 50 per cent or 60 per cent doesn’t actually tell you much about how risky that loan is. A building could be financed at a 50 per cent LTV and still face trouble in an environment of rapid structural change.

For lenders, it is more important to determine how critical the physical space is to the occupier’s operations, both now and in the future. Put simply, how important is it to this business that people are present in the building? Once lenders have answered that fundamental question, they can address the appropriate rent level, the structure of the agreement, the credit quality of the tenants and, in turn, the more traditional metrics like LTV and debt-service coverage.

Another important consideration is the length of the loan. From an investor standpoint, being able to secure longer-dated exposure is helpful in terms of reinvestment risk. Investors deploying capital for a short period, such as two or three years, face the possibility of lower yields upon reinvestment at the end of this period.