Debt Market Snapshot

The economy has continued to grow this year and is expected to continue to do so into next year, according to the ONS and Bank of England, who forecast 7.25% and 6% annual growth this year and next. However, this positive outlook is tapered slightly by increased concerns over labour shortages and inflation, which is increasingly being factored into forecasts, and which could have a significant impact on the market.

The CRE market has benefitted from the improving economy as well as from the increasing number of people returning to their offices after a prolonged period. The City is at its busiest since pre-Covid and the West End is also seeing an increase in footfall. Sentiment has picked up; however, this uptick has not been equal across the market. We continue to see increasing demand and positive outlooks for industrial units, data centres, elderly care facilities and in the multi-family sector. According to Savills, take-up of industrial units of 25.1m sqft in H1 was the second highest on record. Retail units, however, continue to struggle. While expectations improved slightly over the last quarter, RICS rental expectations suggest there will be more struggles for the sector, especially in secondary retail units.

The CRE lending market has also had a very strong first half of the year. The latest report from Bayes Business School found new lending in the UK in H1 amounted to £23.3bn, higher than at the same point in 2019. Lending activity was particularly resurgent among lenders with smaller balance sheets, with smaller balance sheet lenders accounting for 44% of new lending, nearly half of which was used to re-finance loans from other lenders. While the lending market remains competitive, the report found margins for prime office loans rose by 12bps in the first 6 months of the year while prime industrial margins rose by 22bps. Average LTV ratios remain at a conservative 56%.

Banks are returning to the lending market and remain the largest lenders in the UK, however, they continue to be very selective on asset class, predominantly focussing on ‘beds, sheds and meds,’ with a preference to support lending for existing clients or sponsors with very strong track records.

In the alternate lending space, we continue to monitor the frequent new entrants to the market. A report from Prequin found the number of real estate debt funds in the market increased from 117 to 144 over the course of last year, and this number is only increasing. In the UK, debt funds were the second strongest lenders in H1 of this year, providing 24% of new financing. Some of the new debt funds have specific credit strategies, targeting particular asset sectors or jurisdictions, whilst others are broader and can consider most asset classes across Europe. In parallel, established debt funds and alternative lenders continue to raise further capital to lend in the market. Some reports predict that non-bank lenders will account for 40% of CRE new loan origination over the next 2 years. This has created an extremely competitive lending market, where lenders can be more flexible and accommodate value-add strategies and/or provide higher leverage than banks.

Inflation has increased sharply to 3.2% in the UK, (the highest figure in almost a decade), pushed up by higher food and restaurant prices initially but now most critically by rising energy prices, with further upward pressure from wage inflation as a result of labour shortages, which are likely to continue to have an impact in the medium term. It is hoped the closure of the Furlough Scheme at the end of last month will ease the pressures on the labour market slightly, with job vacancies hitting an all-time high in the last 3 months.

While the ONS said the rise in inflation was likely to be temporary, some economists are suggesting that inflation is set to head even higher to 4.5% or even 5% by Christmas, before slowing sharply next year. There is certainly a risk that higher inflations will gradually become more embedded in expectations.

The rise in inflation also brings about the increasing risk of a rise in the Bank of England base rate in order to bring inflation back down towards their 2% target. There is, therefore, some concern that a rate increase would damage confidence that is driving corporate valuations, consumer spending, and CRE asset values. However, the Bank of England has acknowledged that its previous projection for consumer prices was too sanguine. Despite upgrading peak inflation to 4%, it has continued to take the view that inflation will gradually return to the 2% target within the forecast period; with the headline rate expected to peak in the first quarter of next year.

ESG strategies are fast becoming essential. We are now seeing an increasing number of large institutional lenders as well as small and mid-cap credit funds developing sustainability strategies and incorporating sustainability factors into their decision-making.

There is currently no ESG-related regulatory obligation on banks, although that could change in the next few years and many of the large banks and insurance lenders we speak to are aiming to get ahead of the curve and establish robust ESG strategies. The large banks and insurance lenders are very focussed on this and as institutions feel they have a responsibility to drive education in this space. Many of their clients will not yet be focussed on ESG and will view it as something that is ‘coming down the line’ and therefore these lenders are educating but also aiming to incentivise CRE clients through the development of ESG-linked products.

In the credit fund space, a large driver for embracing ESG in a big way, has been the motivation of LPs. Investors are asking more and more of the platforms they invest in when it comes to sustainability, and these platforms have to adapt in order to continue to attract the same levels of investment. According to Morningstar, ESG funds saw an 84% quarter-on-quarter rise in inflows the Q4 of last year, and this trend is causing existing funds across sectors to introduce ESG criteria and look to re-model themselves to fit in to this investment trend.

Very broadly, this will mean incentivising clients to meet ESG targets through margin adjustments. We have seen a number of high-profile examples of green loans, RCFs and bonds, mainly for large generic corporate deals – but the challenge is how to create a bespoke product for CRE; how to benchmark assets, measure performance and to sensibly incentivise borrowers for meeting targets that are achievable but not too easy or just meeting basic regulatory requirements.

There are also other independently certified measures such as BREEAM and NABERS which measure the sustainability performance of a building in-use but one of the current limitations is insufficient data – many borrowers are not preparing ESG reporting to the degree needed so it is likely to be an iterative process.

We have also spoken to small and mid-cap credit funds who do not have the same drivers yet are also focussing on ESG initiatives when considering new mandates, and in cases offering ESG incentives – for example, a 25bps margin reduction once 90% portfolio had reached an EPC target.

Similarly for valuations – as more data becomes available around environmental risk and the ESG performance of tenants, then there should be a premium for sustainable assets. Many valuation teams within surveying firms are considering ESG as a factor when undertaking valuations. As a combination of these factors, borrowers could benefit from sharper margins and capital value increase.

It feels like ESG factors will quickly permeate the whole CRE market and are here to stay.