Debt is becoming increasingly scarce, with banks retrenching even more in the past few weeks.

Unlike the U.S. where banks only make up 40% of the commercial real estate (CRE) lending market, banks in continental Europe account for 90% of the market, and 75% in the UK. Regulatory changes of higher risk weightings for CRE debt have reduced the bank loan exposure in recent years, and current market turmoil and a looming recession has further reduced banks desire to lend in 2023, with banks focusing on reducing their exposure on existing loan books. As banks retrench, it is estimated that the coming three years will see significant volumes of maturing loans, particularly in the UK, Germany, and France. In parallel, the rise in interest rates in 2022 has led to interest coverage ratios being stressed and to falling asset values, also putting stress on loan to value (LTV) covenants.

The debt funding gap due to these covenant breaches and falling valuations is estimated at over €50bn, which is pushing banks to ask for additional equity on refinancings, something many sponsors are unable or unwilling to inject. Suddenly, private debt funds, the lender of last resort, are now the only provider of such capital.

This will likely unfold in three stages: Owners and developers will first try to amend and extend existing loans, which banks are starting to push back on after being accommodative after COVID. This will open the door to alternative lenders, and we expect the market for refinancing to be very active this year. Second comes forced sales from borrowers who could not refinance or inject the needed equity. This has already started with large Real Estate companies selling large assets to meet their covenants but is expected to strengthen towards the second half of the year. This will open the market for acquisition financing at attractive day-1 debt yields. Stage three is when the dust settles and land values respond, and development/capex programs become attractive again. In some situations, we are already seeing signs of stage 2 and 3.

While this is for Europe in general, the UK and Germany remain the two biggest, most liquid markets and where most of the opportunities are.

UK Real Estate Market

As with almost every asset class globally, the UK real estate market is in the middle of a sizeable and rapid correction, heavily accelerated during the fourth quarter of last year. Investment volumes started the year strong but ended thin and down 70% YoY in Q4, with debt costs rising to well above net operating income (NOI) yields. Since March 2022, NOI yields have widened by 50-200bps, which, depending on the sector and submarket, means price declines of above 10-30% or even higher. Sectors like Prime Grade A office, student accommodation, and data centers have generally stayed robust with more modest declines, while industrial and warehouse assets saw the largest percentage drops.

One contributing factor to the robustness of some sectors is availability. For prime office in the West End market, vacancy remains at 5%, with new and refurbished buildings making up only 30% of the available space. The extremely tight market is reflecting well on rents, with asking rents increasing over the past year, partially offsetting the effect of expanding cap rates. By 2026, it is expected that the higher take up and limited supply will result in a shortfall of 4m sqft. Similarly, assets in Life science and the living sectors (residential, senior living, student accommodation) remain better equipped to face the current slowdown.

How Petiole Can Help You

As part of Petiole's diversified private market investment programs, we have been investing in real estate to capture long-term growth trends in developed markets. We provide you with access to the best-performing real estate solutions without having to commit large sums of capital up-front. This means that higher returns are possible without the need to take on more responsibility or higher risk (or both).

Contact our expert team today to find out more about how private real estate can be a valuable asset in your portfolio.

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