RELATIVE VALUE OF UK COMMERCIAL REAL ESTATE DEBT UNDER FURTHER PRESSURE DESPITE SLIGHT RISE IN MARGIN
Lending margins to UK commercial real estate (CRE) inched upwards in the third quarter, but a more significant widening of spreads on CMBS meant that, within the real estate debt spectrum, private senior lending weakened in relative value terms. Against non-CRE forms of debt however, most notably Gilts and Corporate Bonds, senior CRE debt remains an attractive value play.
After working hard to fulfil annual lending targets in the first half of the year, a number of lenders have chosen to be more circumspect since the Summer, with the result that senior margins edged upwards by c5bps over the third quarter. At the same time, spreads on CMBS have increased by significantly more over the same period. CMBS pricing, in other words, has been much more responsive to the global market jitters that have afflicted investors over the past three months. As a result, BBB CMBS now offers an 80bps premium to senior CRE debt, compared to a 20bps discount six months ago.
We noted in our last update that the ‘once-in-a-generation’ returns of a couple of years ago, when senior CRE debt gave a premium over Gilts of 4%+, have gradually given way to a market where the returns on offer pretty much match reasonable expectations. With little significant change in lending terms or in underlying property market outlook over the past few months, this remains the case – non-bank lenders are still getting a very nice premium over Gilts, bank lenders are still meeting or exceeding typical benchmark Return on RWA targets. However, past experience suggests that markets are seldom all things to all men for long; it is only natural to expect returns to come under renewed pressure in the future, at which point those lenders who have been most careful in their selection of borrowers and assets will see the greatest rewards.
That said, real estate debt undoubtedly still offers attractive returns to all forms of lenders, which is why the pool of capital chasing the sector is as deep and varied as at any time in the past. CBRE’s forecast is that average risk adjusted returns to senior CRE lending made in Q3 2015 will be 3.4% pa – a little lower than in Q2, thanks to a decline in the five year swap rate, but still a premium of more than 2% over five year Gilts and of more than 1% over the iTraxx indicator of Corporate Debt. This level of premium relative to other forms of fixed income will continue to appeal to non-banking lenders, while the banks should still be attracted by healthy returns on Risk Weighted Assets – as of Q3, risk-adjusted RoRWA is forecast to be in the range of 1.6-3.1%, depending on Slotting treatment.
To view the full Debt Prospects MarketView please click here