The corona pandemic has caused many real estate banks to be much more cautious in their new business. Project developers in particular are feeling the effects in the form of higher requirements for loan collateral, pre-letting ratios and loan-to-value ratios. In this uncertain environment, alternative forms of financing are gaining in importance. The days when mezzanine was an exotic product with (too) high interest rates seem to be finally over. The authors describe the most important trends in the market for alternative financing and come to some quite remarkable conclusions, particularly with regard to the risk appetite of individual players.
The Corona crisis is slowly but surely leaving its mark on the real estate and project finance markets. Above all, it can be observed that banks and savings banks, as traditional lenders, are becoming increasingly risk-averse and are withdrawing more and more from lending on portfolio purchases and project developments. They are being followed by alternative lenders - all the way to whole loans, i.e. the entire financing package. This is changing the financing structures on the real estate market, in some cases permanently. What are the causes and what will the new financing structures look like in the end?
First of all, the pandemic is changing the valuation parameters for some types of use. Residential and core office properties in prime locations are not affected at all or only very slightly. However, risk discounts in the form of lower purchase price multiples can already be observed in individual cases for lower-quality office properties in B and C locations, not to mention the hotel and retail sectors, where changed earnings forecasts are now also being priced in. A new equilibrium has not yet been found here. Risk managers are therefore taking a closer look at the moment: Investors are questioning their yield expectations, while financiers are becoming more cautious about the level of loan-to-value ratios and are adjusting their terms. Speculative purchases or projects, i.e. without a sufficient portfolio of pre-let properties, are now rarely financed by traditional banks in the office segment.
For traditional credit institutions, the restraint in new business has several reasons: Firstly, banks and savings banks have to back the financing on their own books with regulatory capital. Due to an unfavourable risk weighting, the capital requirements for real estate financing in higher loan-to-value ratios and for project developments are relatively high. This makes refinancing more expensive - and makes loan-to-value ratios above 60 percent unattractive from the bank's point of view. This is the consequence of Basel III - Basel IV is already in the starting blocks - and applies all the more as the gap between official loan-to-value ratios and actual purchase prices has grown steadily in recent years. Secondly, the banks are preparing for economically challenging times and are therefore keeping their powder dry in the form of higher risk provisioning. Accordingly, they are being selective in their new business. Thirdly, staff capacities are often concentrated on negotiating extensions and avoiding risk, or are taken up by the challenging day-to-day business caused by the pandemic, such as the provision of Corona aid.
This opens up new opportunities for alternative debt instruments from loan funds or institutional investors. Until now, the activities of alternative providers have mostly been limited to subordinated capital and the higher loan-to-value ratios. A classic financing structure traditionally consists of the senior tranche up to about 60 percent, provided by banks and savings banks, and the mezzanine portion with the junior tranche up to about 85 percent. The remainder is topped up with liable equity.
Now, however, it is becoming increasingly common to observe that the financing bank is prepared to go along with ever lower loan-to-value ratios. This is where the alternative lenders are moving in. This means that they, too, are taking much smaller risks. Another observation fits in with this: before the Corona crisis, mezzanine capital was mainly in demand for financing project developments. In the meantime, however, alternative debt financiers are also increasingly being called upon to finance portfolio acquisitions, another indicator of the advance into more risk-averse areas. In any case, the impression that mezzanine financiers are blind to risk would be a fallacy: providers established on the market have long been practised in rejecting financing requests even if they do not fit their own risk profile - in most cases, more than 90 percent of the requests fall through. In addition, attention is paid to a significant equity investment on the part of the investor or project developer.
In addition to the strategic restraint of many banks in new business, a second factor is playing into the hands of alternative competitors: speed. In times of the Corona pandemic and lockdown, anyone who wants to take advantage of isolated opportunities to enter the market is dependent on quick decisions. This is exactly what most banks and savings banks are currently unable to provide on the financing side, at least not in new business. Several weeks, sometimes months, pass between application and disbursement, especially as pandemic and home office additionally slow down the decision-making process. This makes it impossible to finance a successful purchase. Alternative lenders, on the other hand, have shorter and less bureaucratic decision-making processes. They can often make a decision on a loan application within a few days. The prerequisite is that they have resilient and scalable digital valuation models and processes as well as short internal decision-making paths.
The result is that in a small but growing proportion of financings, the traditional banks are no longer being approached at all, not even for a very conservative senior tranche of 50 to 60 percent LTV. In such cases, the alternative lender is requested for the entire financing, i.e. the whole loan, and thus completely steps into the shoes of a classic bank or savings bank.
However, lower risk exposure inevitably goes hand in hand with lower interest rates. The alternative lender can still command a certain premium in the market for its faster approval processes. Nevertheless, interest rates on lower LTVs are no longer particularly attractive to a mezzanine loan fund in low interest rate times. Therefore, loan funds often syndicate the senior tranches - and this is where the banks and insurance companies come into play again.
At first glance, it may sound grotesque that mezzanine capital providers initially take over these tranches because banks are reluctant to do so - only to then sell the senior loans back to the banks. On the one hand, this is about diversifying the existing real estate financing portfolio and, on the other, it gives banks without their own real estate financing division and corresponding infrastructure access to attractive senior financing. The German banking market is very local and fragmented. In addition to the national banks, the local savings banks and/or cooperative banks are the market leaders in many regions. There is a reluctance to take on new business locally, but at the same time regional banks and savings banks are sitting on high deposit surpluses that are reducing profitability. If the institutions come from rural areas, they can hardly invest them locally at adequate interest rates. Purchasing receivables from the developer of a large real estate project in a metropolis like Berlin can be an attractive asset outside the home region in times of low interest rates. Moreover, several such project financings can be bundled into one interesting interest-bearing investment. Ultimately, it is not only the bank that benefits from this transaction, but both sides, as the mezzanine capital provider now has greater scope for granting further financing.
As is so often the case, Corona has once again significantly exacerbated an existing trend: credit funds and mezzanine instruments were already on the rise. But it is above all the speed factor, which can be decisive in a market environment of isolated opportunities, that is currently playing into the alternative providers' hands. It is to be expected that this development will accompany us even after the end of the Corona pandemic: In the crisis, alternative lenders are morphing into decisive players in the financing market with short decision-making paths - and with the potential to enable a more diversified asset side for regional banks and savings banks, to the benefit of all involved. This will endure in the long term.
Authors: Maximilian Könen & Lucas Boventer