Relative value of UK commercial real estate debt narrows as achievable margins tighten
- Key Metrics for Banks and Other Lenders Under Pressure -
Lending margins to UK commercial real estate (CRE) fell for the second consecutive quarter resulting in a narrowing of key performance measures for both “traditional” lenders and other newer entrants such as insurers and debt funds according to the latest analysis by global real estate advisor CBRE.
In absolute terms, CBRE’s forecast is that average risk adjusted returns to senior CRE lending made in Q2 2015 will be 3.7% pa. While the premium to five year Gilts, at 2.2%, remains above the long-term average, it has fallen by 1% over the last six months. Furthermore, spreads on other fixed income investments generally widened over Q2; combined with the narrowing in CRE debt margins, CRE lenders’ saw their attractiveness as a value-play shrink; BBB CMBS now offers a 50 bps premium to senior CRE debt, while senior CRE debt’s premium to corporate debt fell to 1.4% from 1.7% three months earlier.
For the banking sector, on the key measure of return on risk weighted assets (RoRWA), returns are also under pressure. Risk adjusted RoRWA is forecast to be in the range of 1.6-2.6%, depending on Slotting treatment, compared with 1.8-3.0% at the end of Q1 and 2.4-4.0% at the end of 2014. In other words, despite benefitting from a much lower RWA requirement, “Strong” loans now only offer approximately the same return as that delivered by “Satisfactory” loans six months ago.
Real estate debt undoubtedly still offers attractive returns to all forms of lenders, which is why there is such a deep and varied pool of capital chasing the sector. But there is no doubt that on an absolute basis we are approaching the limit of stated return premiums required by banks and other lenders for the commercial real estate market. Furthermore, while the returns on offer from senior CRE debt remain above long-term averages, other instruments such as UK BBB CMBS, which may be perceived as a comparable but more liquid alternative to senior CRE debt, have gained in relative return.
For banks, returns on risk-weighted assets are approaching the level of around 2% where they may not meet cost of capital hurdles; for other lenders, the relative value play that enticed them into the sector has narrowed noticeably. We may therefore be approaching a point in the market when lenders’ resolve is tested – and lender/borrower dynamics will be interesting to note in the next six months – who blink first? Lenders may want to resist further downward pressure on margins to stabilise returns, or the requirement to place capital may force them to accept lower margins and higher risk as the price of winning business.
Either way we should expect an even greater focus on relationships, assets, covenant and lending terms from lenders in the second half of 2015.