European banks are scaling back commercial real estate lending on the back of tighter capital requirements under the ‘Basel III’ rules. The retreat has opened the door for private credit funds to move deeper into property finance.
“Today even the largest property companies and private equity funds are happy to deal with non-bank lenders,” Andrew Radkiewicz, global head of private debt strategy and investor solutions at PGIM Real Estate, told Investment Officer in an interview.
Radkiewicz explained how investor demand for income-driven strategies is accelerating the shift, with private debt funds stepping up to finance developments and value-add properties in segments where traditional banks are now less active. He also addressed how PGIM is leveraging Luxembourg stuctures.
IO: The Basel regulations are forcing banks to scale back their commercial real estate exposure. How much of this gap do you expect private credit to fill?
Andrew Radkiewicz: “The Basel regulations have been increasing the cost of capital of banks since 2008, with the latest Basel III Finalisation placing further pressure on balance sheets. The immediate effect has been a significant reduction of both the volume of bank lending to real estate, as well as a focus on core, low risk investment property transactions. Therefore, we have seen alternative lenders increasingly enter the mainstream lending market, across the risk return spectrum.”
“Whereas 10 years ago, borrowers, particularly in mainland Europe, were reluctant to borrow outside their banking relationships, today even the largest property companies and private equity funds are happy to deal with non-bank lenders. This is not a surprise, as we have seen the corporate direct lending market almost entirely replace banks in much of the private lending market.”
IO: What structural shifts are needed for private credit to expand significantly in Europe?
Radkiewicz: “We have already seen that the UK market has seen alternative lenders gain over 30 percent market share of lending last year. European countries such as the Netherlands, Ireland, Spain and Italy are also seeing growth in private credit. Germany has seen a significant growth in private debt funds, however, it is important to note where this appetite lies, both in credit structure and real estate risk.”
“With respect to real estate sectors, it is fair to say that the bulk of new lending is still focused on Living (student, co-living, PRS and senior living) and Logistics. Interestingly, risk assessment has significantly shifted to exit/repayment. As an example, development funding for a brand new prime asset, although maybe considered high risk, has the benefit of the lowest exit risk, due to potential for higher rental growth and investor liquidity.”
”So structurally, we have already seen significant change, where private credit is taking disproportionately higher market share in new developments and value add properties.”
IO: Where do you see the best risk-adjusted returns in property lending today, and how do you assess potential downside risks?
Radkiewicz: “We do believe that real estate values have bottomed out and we are heading into a period of recovery. However, we do not believe that there will be a big capital value ‘bounce-back’, as interest rates stay higher for longer and recent geo-political events are creating an uncertain investment market. However, projections point to a measured recovery of values of circa five percent per annum across Europe, although there will be differences between asset classes.”
“The key to note is that this growth is likely to be almost entirely income driven – a combination of yield and rental growth. Compared to previous cycles, this is unusual. Therefore, from a portfolio construction perspective, if the primary returns are going to be generated by the income side of the real estate equation, then debt investment can offer an attractive diversification. In fact, current returns on debt investments, be they whole loans, subordinated debt or development finance, show a clear, comparatively high income driven return.”
”In addition, when compared to other types of private credit exposure, such as sponsored direct lending, the fact that real estate has already had a negative 30% value drop, means that underwriting on the downside is likely to be less volatile than other asset classes where there is yet to be a correction. The current climate also makes priority, secured, income driven investments a good, low volatility diversifier.”
IO: What return expectations are investors setting compared to other fixed income or alternative assets?
Radkiewicz: “As noted above, investors that have previously only focused on corporate private debt, are now expanding into other classes such as asset backed lending and real estate debt. It is unlikely that this trend will reverse anytime soon. Investors from the private credit/fixed income allocations, tend to favour senior debt strategies offering between c6-8% annual returns unlevered/levered. Investors looking to their real estate allocations, look for double digit returns, available from high yield strategies.”
IO: Do you foresee European regulators playing a more active role in shaping the private credit market, given its expected growth?
Radkiewicz: “Although the sheer scale of growth in private credit is undoubtedly drawing the attention of regulators, this would probably be initially focused on the huge level of private corporate lending. However, if we look at the banking regulations as a guide, Basel II was first introduced in January 2008. On the basis that private debt investments are in the three-to-five year range, regulatory change is probably not a primary risk to investment managers.”
IO: How is PGIM using Luxembourg structures to facilitate private debt strategies?
Radkiewicz: “Luxembourg is definitely a primary jurisdiction for private debt funds. However, the market is evolving and we are seeing increasing growth in open-ended fund structures, as well as, the growth in side-cars and managed accounts. Luxembourg structures offer efficient solutions for the creation of lending vehicles that can sit alongside funds and collectively participate in loan investments. This efficiency is becoming increasingly important to investment managers of debt strategies, as the ability to provide different solutions beyond traditional funds, or the growth in multi-asset solutions, increases the demand for effective structures.”