01 September 2023 - IREI Institutional Real Estate

Private equity investors covering the financing shortfall

Author: John Amram

The loans policies of the classical financiers in Germany have never been as restrictive as they are at present. Among other things this can be seen in the latest BF.Quartalsbarometer from Bulwiengesa: the mood of the banks is even more negative than it was at the height of the coronavirus pandemic. Whereas at that time it was a short, one-off effect, the extreme reservation has been in evidence for nearly a year now, however. A mere 44 per cent of all the surveyed banks are prepared to finance classic residential real estate developments, for example; at least in the case of office real estate projects the figure is still around 60 per cent. Hotels, care facilities and retail projects are being financed even more rarely.

Even in the field of portfolio properties more and more banks are backpedalling: the corresponding office properties are now only being refinanced by 76 per cent of all lenders, in the case of logistics properties – regarded as a boom industry only a few months ago – the figure is 64 per cent.

At the same time, more and more project developers are being confronted with the harsh reality of having to desperately seek financing so that they can operate – while in the meantime work on building sites has come to a standstill and additional costs (and opportunity costs) are incurred with each day that passes. Even large developers have been left paralysed because they have to channel a vast amount of their work into concluding refinancing at acceptable conditions. And yet if a bank agrees to financing in principle, the battle has not yet been won. The required equity ratio is progressively increasing, with as much as 60 to 70 per cent being demanded for some properties. Accordingly, mezzanine capital is now also at a premium.

Private equity investors and insurers entering the financing market

In the meantime this constellation of enormous demand and very limited supply has also been acknowledged by private equity investors, insurers and family offices from throughout Europe, the USA, the Middle East and the Asian region. In this respect the spotlight is on actors from the Anglo-Saxon regions above all. These have consistently been raising capital for months now – something which has already been observed extensively by participants on the German real estate market. There is an ongoing discussion in the specialist community, however, as to when these investors will push up the transaction volumes once again in the form of asset and share deals.

In reality, however, the fact is that these actors are already entering the German real estate market in larger numbers – often not as buyers, however, but as financiers. In this respect it is the more flexible investor types in particular who are employing widely different models. Alongside mezzanine capital, subordinated loans and joint ventures, the focus of alternative financiers is increasingly also on senior and whole loans.

Which alternative forms of financing are currently seeing particularly strong demand?*

Form of financing Q4/22 Q1/23
First-ranking securitised debt capital instruments (e.g. bonds/whole loan structures) 15.4 % 19.0 %
Subordinated securitised or unsecured debt capital instruments (e.g. bonds/senior unsecured corporate bonds) 10.3 % 17.2 %
Mezzanine capital (e.g. subordinated bond or loan) 33.3 % 31.0 %
Equity capital (e.g. private equity or joint venture) 30.8 % 20.7 %
Indirect financing through forward commitments 10.3 % 12.1 %
Other instruments 0.0 % 0.0 %

*Multiple responses possibl

Source: BF.Quartalsbarometer Q1/2023.

Win-win situations in preferred locations

For the insurers, private equity investors and family offices who act as financiers there is a high level of security in many cases. For example, they can specifically search for prime properties and developments in preferred urban locations which require refinancing and then award the necessary senior loan. With the corresponding contractual conditions and adequate securitisation their own risk is then minimal. In the majority of cases they receive an attractive, fixed-interest cash flow, while as a tangible asset the underlying real estate offers inherent protection against inflation, . Should, for whatever reason, the contractual partner nevertheless find itself in difficulties, a first-ranking provider of capital can secure ownership of a sustainable property, which could have been considerably more expensive with a classic share or asset deal.

Returns of as much as 20 per cent on replacement equity capital are realistic

A closer look at the survey mentioned right at the outset reveals: for all properties which fall into the category “other real estate” and which do not belong to the more common asset classes, the willingness of banks to provide financing is non-existent – meaning that conventional loans are not awarded for investment projects that lie outside the norm. This is consistent with what is being experienced on the market. For instance, as a rule large-scale photovoltaic installations have to be financed one hundred per cent with equity capital – despite the declared intention of governments to bring about an energy turnaround. The situation is a similar one for investors currently conducting land banking and wishing to acquire undeveloped plots of land.

This equity capital or replacement equity capital frequently increasingly originates from private equity investors and the other above-mentioned market players. As the corresponding projects are associated with greater risk than the refinancing of existing properties, the lenders ensure their liquidity is rewarded well. As a consequence of the diversity of projects and the differing starting positions of the borrowers, the conditions also differ from case to case. Nevertheless, fixed interest rates of between ten and 20 per cent are customary for this replacement equity capital in the meantime, often also accompanied by additional incentives such as a share of the profits from a project. Furthermore, for investors from outside the eurozone there is often also the possibility to attain positive currency effects. Above all the strong US dollar is a positive factor in this regard – even if the lack of transparency with currency developments means that it only rarely evolves into the decisive factor. Rather the tactic of the borrowers is often that of raising the capital to push ahead with a project and subsequently refinance it at more favourable conditions with fresh borrowed capital.

Flexible approach rather than rigid dogmas

More so than with classic asset and share deals, the important aspect with alternative financing models now is the flexibility of the two parties involved. The respective investment projects vary greatly, which is why the details differ considerably from case to case. Accordingly there is only a limited opportunity to invoke “best cases”. This is why the careful preselection of the respective trading partner is all the more important. Ultimately the current market situation is extremely challenging and the wide variety of market drivers – from the shift in interest rates, through the explosion in construction costs, to regulatory and ESG-related issues – means that it is scarcely possible to arrive at a reliable prognosis as to how the markets will develop in the coming months. Thus more than ever before the key factors are the dependability of the contractual partner and accurate matching of lender, borrower and the underlying investment project.