Redington CRE Debt Opportunity March 2013

5/28/2018 Redington CRE Debt Opportunity March 2013

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European Commercial Real Estate Debt

March 2013

For Institutional Investors


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Executive Summary

Redington has recently identified an attractive opportunity which falls into step 5of our 7-Stepframework1. We believe that opportunities within European Commercial Real Estate Debt (CREDebt) have the potential to deliver highly appealing risk adjusted returns.

The asset class consists (usually) of floating rate loans secured against commercial real estate

with an average life of about five years.

The opportunity arises from the demand-supply mismatch currently present in the market. On theone hand, demand is very high, as the mountain of lending generated between 2005 and 2008 is

now coming due and the need for refinancing is considerable. At the same time, the traditional

suppliers of capital banks now face a considerably different regulatory environment than

before the crisis. Under Basel II and the upcoming Basel III frameworks, the capital buffers that

need to be held against CRE Debt are significantly higher and as a result, banks are seeking to

reduce their overall exposure to this asset class.

The retreat of banks, regulatory changes and lessons from the recent financial crisis have all

served to significantly change the risk-reward profile of the asset class. First of all, lendingst nd rds h ve gre tly improved in the lenders f vour . The loan-to-value (LTV) ratios on seniordebt have fallen from up to 80 to 50-60 .Simultaneously, the loan spreads on senior loanshave widened to levels previously hardly attainable even on mezzanine debt and are currentlystanding at 300-450 basis points (bps) above LIBOR. Mezzanine loans spreads have increased to

as high as 900-1300 bps above LIBOR.

It is, however, important to be aware of the risks the CRE Debt carries. It is an illiquid asset class,with only limited secondary trading. Secondly, there is significant occupancy risk. In other words, itis important that if a tenant leaves, he or she can be easily replaced. For this reason, we believe,

investors should ensure that the asset manager managing the portfolio has sufficient knowledgeand expertise in the real estate markets to be able to manage these risks. This also ties in withthe need to analyse the underlying assets for their potential resilience to negative market shocks.

We have met a number of asset managers in the space and are comfortable that we are able toselect a provider, which is able to effectively manage these risks.

1Please see the Appendix 1 for more information about our Seven Steps to Full Funding framework.


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What is Commercial Real Estate Debt?

Commercial Real Estate (CRE) Debt consists of fairly illiquid, usually floating rate loans backed by

commercial real estate, such as offices, retail, hotels, etc. A simplified explanation of the mechanics

of such loans is contained in the diagram below:

Figure 1: Commercial Real Estate Loan Stylised Example

Source: Aviva Investors, Redington

A sponsor, typically a fund, private equity house, property company or a high net worth individual uses

equity and debt to finance the purchase of a commercial real estate building (or buildings). Rental

cash flow stream then is used to cover the interest payments on the debt. Given the nature of the

underlying assets, the size of loans is typically relatively large, in the range of 10-100m, with a

balloon payment2made at maturity. In the event of a default, the lender, depending on its position in

the capital structure, receives a portion of the liquidated underlying asset.

The table on the next page summarises the most important information on the asset class.

2Balloon payment large payment made towards the end of the life of a loan. Balloon payments typically apply in the case of

non-amortising or partly-amortising loans, which leave a high proportion of the principal outstanding until the final payment.

Sponsor

(Property

Owner)

Lender

Commerical

Property

Tenants

The lender has a lien

on the underlying

property

Principal + Interest

Loan advance


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Figure 2: European Commercial Real Estate Debt Summary Table

Characteristic CRE Debt

Public/Private Private, unrated

Coupons Mainly floating (but fixed also possible)

Underlying assets Commercial Real Estate (e.g. offices, retail,warehouses, healthcare, etc.)

Sponsor Recourse No recourse

Typical loan size 10-100m

Liquidity Illiquid; limited secondary market

Typical Life Average of 5 years

Prepayment Yes, but penalties apply (2-5%, depending onthe year of prepayment).

Typical Lenders Banks though now increasingly insurancecompanies and fund managers

Typical Borrowers Funds, private equity houses, propertycompanies and high net worth individuals.

Upfront fee 1-2% of the amount borrowed is paid by theborrower to cover the arrangement fees.

Current loan-to-value ratios on senior debt Up to 60%

Current loan-to-value ratios on stretch-seniordebt

Up to 75%

Current loan-to-value ratios on mezzanine debt Up to 90%

Current spread over Libor on the senior debt 300-450 bps

Current spread over Libor on the stretch-seniordebt

500-800 bps

Current spread over Libor on the mezzaninedebt

900-1300 bps

Source: DRC Capital, M&G, CBRE, Cairn, Aviva Investors, Redington

Opportunity in Europe

We believe that a fundamental imbalance exists in the European CRE Debt market and this creates

an attractive opportunity to large non-bank institutional clients. Here, we provide an overview of the

current market demand and supply dynamics.

Supply shrinks...

The recent bank deleveraging process has created a shortage of commercial real estate financing. In

the past, in Europe, banks have provided 76% of all outstanding debt (this compares with only 55% in


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North America, where insurance companies, pension funds and other investors account for 21%

lenders3).

Figure 3: Estimated Split of European Real Estate Debt by Source

Source: Morgan StanleyFollowing the crisis, banks are under a much stricter regulation than previously. The set of reforms

enshrined in Basel II has already constrained bank activity by requiring banks to set aside a certain

capital buffer against their risk-weighted assets. Under Basel III, the next instalment in banking

reforms, which will be introduced gradually over the course of the next six years, even more stringentrequirements apply. Among these are stricter definitions of capital (higher quality capital will be

required), and an increase in the size of the overall capital buffer required. There will also be controls

over leverage and liquidity ratios. Under these stringent rules, certain assets, especially particularly

capital-intensive ones (such as commercial real estate loans) are likely to see banks retreat. As this

process continues, CRE borrowers will find it difficult to refinance their loans. In the case of the UK,

the problem is even more severe, as on top of Basel II and III reforms, they also need to comply with

the new slotting regime, introduced by the FSA in the first half of 2012. Under this regulation, all

performing property loans need to be allocated to one of the four risk categories. Each category has

assigned risk weights ranging from 50 to 250%. This then translates to the size of capital buffers that

need to be held against the loans.

Morgan Stanley4 estimated that the banks will shrink their exposure to the asset class by 350-

600bn, creating a shortfall of in the range of 400-700bn. As of November 2012, banks were 20-25%

through this deleveraging process, suggesting that a vast majority of the loans will still need to be

dealt with. The deleveraging so far has occurred mainly via repayments (55%) and sales (20%). In

terms of sales, example transactions that occurred in the 12 months to June 2012 are shown below:

3Source: DTZ Insight, Global Funding Gap, 2011.4Source: Banks Deleveraging and Real Estate - Banks are 20-25% through CRE deleveraging, November 2012.

Banks, 76%

Covered Bonds,18%

CMBS,6%


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Figure 4: Example Loan Books Sold over 12 months to June 2012

Date Seller Buyer Description Face Value Sale Price

Jun 2011 Anglo IrishBank

Urbicus Scottish LoanPortfolio

300m Undisclosed

Sep 2011 NAMA BarclaysBrothers

MaybourneHotels

696m 695m

Oct 2011 Bank ofIreland

KennedyWilson

UK LoanPortfolio

1.75bn c1.4bn

Dec 2011 RBS Blackstone Project Isobel 1.36bn 950m

Dec 2011 Lloyds Lone Star Project Royal 923m c550m

Dec 2011 NAMA Morgan

Stanley REI

Saturn/West

Properties

216m c75m

Mar 2012 Eurohypo AXA UK Loan

Portolio

200m Undisclosed

Apr 2012 Bundesbank PIMCO LehmansDiversity

CMBS

1.14bn c740m

Source: Savills, Real Estate Capital Magazine

The decrease in CRE financing is caused not only by a reduction in bank refinancing activity but is also

due to a shrinking number of lenders overall. The recent INREV report 5reveals that because of either

collapse or parent company withdrawal, 42 lenders in the commercial real estate debt space in

Europe have withdrawn. Further, the report shows that 10% of managers could not refinance at least

one asset after a bank lender pulled out.

Although, some activity from new entrants has been observed, this is not sufficient to offset the

retreat from banks. Morgan Stanley estimates that up to 200bn could become available from non-

bank financing providers. This is expected to be driven by bond issuance, as well as the entrance of

insurance companies and sovereign wealth funds.

...but Demand is Likely to Remain High

Prior to the financial crisis of 2008, the European real estate market saw a strong expansion in real

estate lending. This resulted partly from the relaxation of lending standards and partly from strong

growth in the mortgage-backed securities market. As a result, in under ten years, the totaloutstanding debt increased by a factor of 5 in the UK and as much as 10 in Spain6.

According to CBRE, currently about 960bn of European CRE Debt is outstanding, about 50% of which

is located in the UK and Germany. As seen in the figure below, about 170bn of European debt will

need to be refinanced in 2013 while another 130bn requires refinancing in 2014. Overall, about

40% of the total debt outstanding is due to be repaid between 2013 and 2015 (inclusive).

5Capital Sources Survey, November 20116Source: DRC Capital


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Managers in the CRE Debt space are of the opinion that the best quality loans will be refinanced first,

providing a call for early investment.

Figure 5: European CRE Debt Maturity Profile

Source: CBRE

According to DTZ, the European funding gap is about 5 times the size of that in the Asia-Pacific region.

We believe that large defined benefit pension schemes are perfectly positioned to fill this gap, as they

are able to accommodate a certain level of illiquidity while not being constrained by capital

requirements. Insurance companies, although subject to Solvency II standards, can also benefit

significantly, as they can gain exposure to commercial real estate at a considerably lower capital

requirement level than is the case for equity investments.

Improvement of the Risk-Reward Profile of the CRE Debt

The demand-supply imbalance in the European CRE Debt space, along with stricter lending standards,

has led to a significant decrease in the levels of LTV ratios loans are made at. For example, in the UK,

the LTV ratio on new senior debt on core offices fell from over 80% before the crisis down to about

65% in 2011. At the same time, loan margins increased from about 100 bps above LIBOR to well

over 250 bps above LIBOR.

0

20

40

60

80

100

120

140

160

180

200

bn


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Figure 6: LTV Ratios and Margins on Senior CRE Debt Backed by Core Offices in the UK

Source: La Salle

The overall impact of lower LTV ratios and higher lending margins has had an appreciable

improvement on the overall risk-adjusted returns available from CRE lending. The diagram below

shows the evolution of a typical capital structure in Europe over the years since the financial crisis,

illustrating this improvement.

Figure 7: Evolution of the Typical Capital Structure of the European CRE Debt over Time

Source: M&G Investments

0

50

100

150

200

250

300

50%

55%

60%

65%

70%

75%

80%

85%

SeniorLoanMargin

LTV

LTV ratio (LHS) Senior Loan Margin (RHS)


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The CMBS Access Route No Longer Available

Previously, investors used to access the asset class via Commercial Mortgage-Backed Securities

(CMBS). Through use of the CMBS markets, banks could offload mortgages off their balance sheets.

Although CMBS securities enjoyed significant popularity for a period, the market has now dried up

and is practically non-existent. The major driver of this has been regulation, which now forces banks to

retain the equity portion of the CMBS on their own balance sheets. Although, the investor base is

smaller than it used to be before the crisis, the supply effect dominates by far. As a result, the

issuance in any one year between 2008 and 2012 did not exceed $30bn, with 2010 and 2011

issuance below $10bn.

Figure 8: European CMBS Issuance

Source: SIFMA

Risks in CRE Debt

Though we are positive about the asset class, we acknowledge risks inherent in this type of

investment. However, we also believe a large proportion of them are manageable and can be

minimised with the help of a skilled asset manager, who has sufficient experience and expertise in

the commercial real estate markets, as well as in debt structuring. In the table below we summarise

the main risks and how they can be addressed.

Figure 9: Risks in the Commercial Real Estate Debt

Risk Means of Protection or Probability of Materialising

Occupancy Risk Appropriate tenant diversification coupled with

selection of loans backed by properties which suffer

from a relatively low void risk.

Illiquidity This is an inherently illiquid asset class and the

secondary market is not well developed. However

investors are rewarded by an illiquidity premium.

0

10,000

20,000

30,000

40,000

50,000

60,000

70,000

80,000

90,000

$million


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Fall in Property Value LTV ratios on senior and stretch-senior debt typically

provide a 25 to 40% cushion in the form of

mezzanine debt and equity.

Significant falls in property values have already

occurred, leaving the assets less (if at all) inflatedthan before.

Asset manager with extensive real estate

knowledge and experience should be able to

minimise the risk by selecting loans backed by

properties less prone to dramatic falls in value.

Default Risk Mitigated by the security on the underlying asset.

In addition to this, the loan agreements often

contain a range of covenants, ensuring an adequate

level of security. Examples of such covenants

include: Net Operating Income (NOI)/interest ratios,

debt service coverage ratio and LTV ratios.

Illiquidity of the Underlying 50% of the outstanding CRE Debt is in the UK and

Germany. These two countries have the most liquid

European markets and in 2011 they accounted for

50% of the European CRE transaction volume.7

Appropriate security selection should to some

extent mitigate this risk.

Prepayment Risk It is common to apply prepayment penalties (2-5%

of the value of the outstanding loan depending on

the year of prepayment). In some occasions, fulllock-out until maturity might be possible.

Interest Rate Risk Increasing to LevelsUnaffordable for the Borrower

Tenants commonly use swaps to mitigate this risk.

Regulatory Risk We view the risk that regulatory bodies will loosen

the rules surrounding bank leverage and capital

requirements relatively low.

There is, however, a potential risk of changes in the

real estate regulation specifically.

Solvency II ConsiderationsUnder Solvency II standards, the capital charge for direct equity CRE holdings is significantly higher

than that for CRE Debt. According to Henderson Global Investors analysis, the relative cost of holding

commercial real estate directly versus CRE debt will depend on the duration of the loans. However,

given the typical duration of loans currently (5-7 years), CRE Debt is currently a favoured route to

property exposure for insurance companies. We have observed insurance companies entering the

market at lower than market-implied levels. Henderson estimates that currently insurance companies

offer the most competitive loan conditions for borrowers.

7Source: Morgan Stanley


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Summary

An opportunity for non-bank capital to lend to these borrowers at elevated spread levels and at

unusually low LTV ratios has therefore emerged. This has been identified by a number of insurance

companies and asset managers. As illustrated above, loans can be made at almost any LTV range,

with spreads ranging from Libor + 200 bps to Libor + 1300 bps, thus allowing for a customised

tailoring of risk-reward profile. However, it is probably simpler to bifurcate the market into two key

offerings: one which we believe to be generally consistent with investment grade debt and a second

lending opportunity which appears to be more speculative. The first proposition involves making

senior and stretch senior loans, typically up to 65-70% LTV ratios, on core and often super-prime

property. A portfolio of these loans has the potential to earn spreads in the region of Libor + 350-500

bps gross of fees, depending on the exact risk profile required. Fixed rate loans can be negotiated in

some cases, as can amortising schedules as well as extended no-call periods. The second, riskier

opportunity involves participating in a higher LTV mix of stretch senior and mezzanine loans from

the 60 to 65% attachment point up to around 85% LTV. These loans are typically earning in the region

of Libor + 800 bps or more and can involve Pay-in-Kind coupons which only pay off at maturity orsuccessful refinancing.

Access

The main route to access these investments is via an asset manager. Currently, asset managers offer

both primary and secondary debt strategies. We favour the former, as in these cases managers can

have control over the structuring process, ensuring that all their security requirements are fulfilled. In

addition to this, some secondary loans might suffer from the fact that they were arranged a few years

ago, when market conditions for CRE Debt were less favourable.

Managers in the European CRE Debt space we have reviewed include:


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Appendix 1 Seven Steps to Full Funding

St ep Description

1: Clear goalsand objectives

Strategic Pensi on Risk Management Framework that sets out funding objectives,risk budgetandother

constraints such as liquidity and collateral requirements

Flight Plan that charts each plans path to full funding and generates required returns used to set

investment strategy

2: LDI hub Manage unrewarded interest rate and inflation risk through efficient use of enti re universe of hedging

instruments

Centralise and oversee collat eralrequirements

3: Liquid alpha & beta Highly marketable asset classes that generate returns through market risk premia

Examples: equities, commodities, currency strategies

4: Liquid& semi-liquid credit Steadyincome viaregular coupon payments

Bulk of excess returnsare compensation for credit risk

Examples: investment grade and high yield corporate bonds, go-anywhere credit

5: Illiquid credit Long-dated, hold-to-maturity instruments that pay an illiquidity premium

Potential for inflation-linkedcashflows

Examples: infrastructure debt, secured leases, direct lending

6: Illiquid alpha & beta High potential returnsbut often difficult to access and relatively complex

Generally aim to take advantage of market dislocation and more exotic risk premia

Examples: private equity, property, hedge fund strategies

7: Ongoing monitoring Regular monitoring of planprogress against key goals and constraints

iRIS reportsgive the plans a hol istic view of risk and evolution of funding level

Manager reportingcan help identify behavioural and underperformance issues


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DisclaimerThe information herein was obtained from various sources. We do not guarantee every aspect of its

accuracy. The information is for your private information and is for discussion purposes only. A variety of

market factors and assumptions may affect this analysis, and this analysis does not reflect all possible loss

scenarios. There is no certainty that the parameters and assumptions used in this analysis can be

duplicated with actual trades. Any historical exchange rates, interest rates or other reference rates or

prices which appear above are not necessarily indicative of future exchange rates, interest rates, or other

reference rates or prices. Neither the information, recommendations or opinions expressed herein

constitutes an offer to buy or sell any securities, futures, options, or investment products on your behalf.

Unless otherwise stated, any pricing information in this document is indicative only, is subject to change

and is not an offer to transact. Where relevant, the price quoted is exclusive of tax and delivery costs. Any

reference to the terms of executed transactions should be treated as preliminary and subject to further

due diligence.

This presentation may not be copied, modified or provided by you, the Recipient, to any other party

without Redington Limiteds prior written permission. It may also not be disclosed by the Recipient to any

other party without Redington Limiteds prior written permission except as may be required by law. 7

Steps to Full Funding is a trade mark of Redington Limited.

Redington Limited is an investment consultant company regulated by the Financial Services Authority. The

company does not advise on all implications of the transactions described herein. This information is for

discussion purposes and prior to undertaking any trade, you should also discuss with your professional, tax,

accounting and / or other relevant advisers how such particular trade(s) affect you. All analysis (whether in

respect of tax, accounting, law or of any other nature), should be treated as illustrative only and not relied

upon as accurate.

Registered Office: 13-15 Mallow Street, London EC1Y 8RD. Redington Limited (reg no 6660006) is

registered in England and Wales.

Redington Limited 2013. All rights reserved.

Redington CRE Debt Opportunity March 2013

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