The funding landscape in the real estate finance space has changed dramatically since the financial crisis.
Traditional banks withdrew from the market – crippled by exposure to bad real estate debt – leaving a significant liquidity gap as real estate lending dried up. With banks nervous to lend (or in some cases unable to) an opportunity arose for funds and other non-bank lenders to take advantage of this liquidity gap and offer alternative funding solutions to borrowers.
Now, in 2015, as banks continue to face the challenge of increased regulatory demands and the need to deleverage balance sheets, non-bank lenders have become major players in the real estate finance market. It is estimated that almost a quarter of all new lending in the real estate market in 2014 came from non-bank lenders such as insurance companies, hedge funds, private equity investors and debt funds. Indeed respondents to a Loan Market Association survey on “which lending source will demonstrate the greatest growth in 2015” suggested debt funds (32.4%) as the greatest source, followed by banks (21%), pension funds (19.9%), insurers (15.5%) sovereign wealth funds (8.2%) and others (at 3%).
What has driven this growth?
- High returns - Non-bank lenders are drawn to the real estate market by the prospect of high returns over the long term (10+ years) for their investors which compare favourably with other fixed income products such as gilts. Property is viewed as a relatively stable long term investment.
- Risk appetite - Crucially they also have a greater risk appetite, and are prepared to partner corporates where they see added value in the long term. Indeed a non-bank lender may take a strategic equity role in addition to providing the finance on real estate investment or development projects. It is this “big picture” thinking that makes non-bank lenders attractive to corporates, as they can feel confident that their and their funder’s interests are aligned.
- Competitive terms - For corporates, non-bank lenders can offer competitive terms, which take into account corporates’ needs and offer a responsive, flexible and innovative approach, which contrasts sharply with big banks’ lengthy credit committee processes.
Where does this leave the banks?
Whilst it is true that traditional banks have cut lending and focused on regulatory compliance and deleveraging their loan books, this has meant that they are now putting themselves back in a position to return to the market. Indeed post-crisis banks were unwilling to lend more than 60% of the value of a property. That figure is now edging closer to 70% which indicates that banks are starting to get their appetite for real estate lending back, albeit on more cautious and disciplined terms, with emphasis placed on cash flow and the refinancing risk at the end of the tenor rather than valuation.
As for the non-bank lenders it should be remembered that their first priority is their investors. Property can offer a high return over a number of years and is an attractive and stable investment. Yet it could be argued that whilst non-bank lenders have brought increased liquidity into the real estate markets they have done so only in relation to lending which offers the best return for their investors. This is why non-bank lenders prefer a fixed rate, backed by loan documentation which restricts prepayments or, where prepayments are permitted, come with make-whole provisions. These are all designed to ensure that the expected rate of return from the investment is fully realised over the full term of the loan.
Non-bank lenders have undoubtedly helped close the liquidity gap, however they have not replaced banks: they are simply finding the space where the banks have retreated and taking advantage of opportunities which arise and provide a good return for their investment. It is unlikely for example that non-bank lenders would provide overdrafts and revolving facilities to borrowers as these are far too uncertain in terms of return.
The funding landscape in the real estate finance space has changed dramatically since the financial crisis. Non-bank lenders have become major players in the real estate finance market, but banks are cautiously returning to it. Going forward it is likely we will see a highly diversified market place, with different lenders focusing on different sectors with different drivers and challenges. Perhaps banks will focus on more vanilla lending whilst non-bank lenders may focus on more complicated structures where there is potential for a significant return for their investment. Either way, it is clear that non-bank lending is now very much part of the real estate finance market.
Andrew King is an associate at Clyde & Co