We all hear people talking about doing real estate finance deals and talking at drinks events about “the market” but unless we really understand what the market means, it can be a challenge to achieve the most important element in any transaction— getting the deal done.
This article looks at a number of the key drivers for international real estate finance which determine a successful outcome.
Overview of international real estate finance markets—what are they?
Real estate finance is a significant international market on its face but when you drill down it is a range of complex markets with many different drivers. Each of these drivers has an impact on the way that deals get done and the approach that needs to be taken to achieve a successful completion.
Deals can be closed without understanding these drivers but to achieve a successful closing, experience shows that it is imperative to understand certain key points. If you adopt a single unwavering style for all types of deals irrespective of the market in which you are dealing, you may well end up with delays, frustration and a spiralling budget.
So what do we mean by the market? The important point to understand is that the market means different things to different players. A property can be financed both in a domestic market transaction where the borrower and the lender are both domestic entities, transacting under local law often on standard form domestic market accepted documents. Interestingly, and this is a key point, that same property can be viewed completely differently as the asset in an international deal with inwards investment from an overseas borrower, raising debt from its relationship lender who has followed its client to that jurisdiction, transacting on their “home” style documents often under English law, using local law only for the necessary security over the domestic assets. Then mix the two together and have a local lender funding an overseas investor (or vice versa) and it could fast lead to misunderstandings, frustrations and problems where nuances of approach are not understood.
Market deal drivers
So what are these market deal drivers for international real estate finance transactions?
Culture—Some jurisdictions are used to the “big picture” approach on negotiation of documents, leaving the lawyers to sort out the detail; others will settle documents by starting with the first point on page one and not moving on until that point is settled.
Flexibility of law—We have all heard someone involved in a deal say “it must be possible” and then struggle to understand when a legal system does not have the same flexibility and adaptability as that person is used to in their home jurisdiction.
The “unknown unknowns”— When investing or lending outside of your home jurisdiction, it is very easy to assume that the local market operates in the same or similar ways to your home market, both in terms of market standards and in terms of legal approach. For example, it may well be standard for hedge counterparties to benefit from the mortgage taken over the property in one jurisdiction but equally standard in another that the hedge counterparty cannot benefit from property security (which can only benefit a lender) and is an unsecured creditor albeit sitting at the top of the waterfall of payments. The key is to understand the differences between your home system and the local environment and to figure out what you do not know about those differences.
The identity of the lender— The lender community can take very different approaches to transactions depending on their appetite for risk, their internal procedures, their exit strategy (sell down by syndication or securitization or long-term hold) and the nature of the asset and the jurisdiction. Where lenders are used to acting in a certain way in one jurisdiction, that approach does not always translate in another jurisdiction so it is important to be mindful of conflicting approaches.
The identity of the borrower—As with lenders, the approach can differ quite considerably. Similar drivers apply around the longer term strategy and the transportability of structure from their home jurisdictions.
The state of the local economy—The market will be dictated to in part by the perceived balance of risk and reward in jurisdictions and the view of the cycle for the property market as a fundamental to whether a deal makes sense. The weight of money and investment that was made in Germany, Switzerland and Central and Eastern Europe (CEE) in the mid-2000s was in part driven by US and UK investors hungry to invest but seeing those jurisdictions as better value for money given the property yield compression being experienced in the UK. Add to that the underlying demographic around occupancy, opportunities for rental growth and the unavoidable fact that some investors and lenders may be very wary of the economic performance of some jurisdictions whilst others will see those very same uncertainties as the basis of opportunity.
The legal documents— Presenting a Loan Market Association 150-page facility agreement drafted on a syndicated basis in a jurisdiction where the domestic market is used to a 15-page short form facility is likely to get deals off to a bad start. Similarly, a short form loan drafted on a bilateral basis may give some lenders concerns about their ability to sell down the debt or refinance in their local covered bond market at a later date.
Costs—Widely differing legal frameworks between jurisdictions give rise to widely differing costs. The fees for taking and perfecting security vary enormously across jurisdictions giving rise to quite complex structures for avoiding, or at least mitigating, those fees. Understanding those fees and any implications that the structures use to mitigate them is important—both the cost side of things and the ultimate structure used to reduce those costs need to work.
What’s hot and what’s not?
Those were some of the key points in terms of how to approach the transaction management side of an international real estate finance transaction, but unless deals are being done, there are no transactions to manage. So which markets seem to be active in Europe—let’s look at some of the relevant themes in the different markets:
General market trends:
- The two-tiered market in countries that existed in the years following the credit crisis (prime cities where activity remained against the rest of the country where activity contracted greatly) has started to fall away over the past year or so as lenders begin to find their niche in terms of ability to compete on price against appetite for risk. Some lenders compete on price; some lenders compete on size of deals that they are willing to underwrite; others compete on assets that require active asset management with higher property yields; some compete on jurisdictions in which they are willing to do business.
- Macro-economic conditions in Europe have seen some investors believe that opportunities in Asia and America present a better risk–reward profile whilst others believe that the Eurozone crisis is less likely to drive the location of their investment, seeing a return in positive sentiment for some in jurisdictions hit particularly hard in the last few years like Spain, Italy and Ireland (albeit that this should not be over- stated as these jurisdictions remain challenging for some). Investment activity in Europe continues to represent the most significant destination for non-domestic investment. The Asian markets are experiencing a larger degree of outward investment as some of the bigger pension fund players look for stable long term income and less compressed yields.
- There appears to be an increase in appetite for markets other than just the investor’s domestic market. When things are tough, there can be a tendency to retrench to your home market. As conditions improve, those attitudes can relax.
- Relaxation of regulation in some of the Asian markets has allowed outward investment. This has seen a wall of south east Asian money hit Europe in particular benefitting from a yield arbitrage on the real estate, cheaper financing and the acquisition of assets perceived to be trophy assets.
As to asset classes:
- Competition for quality assets in prime cities remains high but yield compression and a lack of stock coming to the market has seen many move out of prime cities to secondary locations chasing assets in which to invest. This investment has been primarily in office, retail and residential.
- The residential markets have been more active than most due, in part, to the shortage of housing stock in many countries. London, in particular, has seen a wall of overseas money buying up residential apartments with Middle Eastern, continental European and Asian investors buying in volume, often off-plan.
- Retail, although unattractive to some, continues to see investment in particular where the site benefits from a lack of local competition resulting in increased footfall and sustainability.
- Development activity has increased primarily for residential. We have yet to see any significant volumes of speculative office development.