European commercial real estate (CRE) lending markets are facing a challenging environment, resulting from a higher than usual cost of debt and falling real estate valuations. In the face of such uncertainties, we examine how private credit funds with a real estate debt strategy might nonetheless take advantage of funding opportunities and what considerations might determine how leverage providers choose to participate.
The business rationale for using leverage in CRE debt transactions is simple. Loan funds typically use the leverage provided by commercial banks to enhance returns on their real estate debt investments at a lower cost than direct (equity) investments in the fund. Back leverage providers in return gain indirect exposure to illiquid assets as well as additional asset-backed structural and contractual guarantees.
Despite the additional operational and structural complexity, in our recent experience banks offering leverage may prefer more structured solutions instead of direct exposure to private credit funds. This is because most funds are unrated, resulting in a 100% risk weighting for the financial institution. By offering leverage in a more structured way, for example by repackaging the CRE loan into a note, private securitization – also known as private label commercial mortgage-backed securitization (CMBS) – a master arrangement repurchase agreement, loan-on-loan or derivative-based financing such as a total return swap (or a combination thereof), return leverage providers may apply a lower risk weighting, which in turn reduces the amount of capital the return leverage provider is required to hold against the exposure. As a result, leverage providers in structured transactions should be able to offer cheaper prices to borrowers of private credit funds.
Leverage providers tend to fall into one of two camps: those who approach funding with a credit mindset (wanting discretionary approvals and eligibility vetoes, haircuts on of each underlying loan and control of a negotiated set of major decisions regarding the underlying loans) and those with more of a fund finance mentality (who do not approve or veto positions relying instead on detailed diversification and eligibility criteria, combined with complex partial haircut mechanisms to define the available borrowing base).
We have seen a range of structuring options emerge to allow private credit funds to diversify their funding sources and potentially tap into cheaper funding, while sharing risk and increasing liquidity in the CRE loan market.
The CRE loan market has undergone significant changes following the Global Financial Crisis (GFC). Prior to the GFC, banks originating CRE debt could avail themselves of a number of bank syndication and financing options, including the sale of sub-equities and mezzanine loans to other financial institutions.
Alternatively, banks could tap debt capital markets to sell exposure to CRE assets through commercial mortgage-backed securitizations (CMBS 1.0), which have flourished as an off-balance sheet financing tool for a while. period of cheap and abundant debt with no regulatory obligation to retain risk. Other options included CRE Guaranteed Loan Obligations (CRE CLOs), although this was (and arguably remains) primarily a feature of US CRE debt capital markets.
After the GFC, a more restrictive regulatory environment coupled with “slotting” rules and capital allocation to risk-weighted assets led to some disengagement of banks from parts of this sector, giving way to an increase private credit. Since the GFC, we have witnessed a kind of role reversal with regard to originators of CRE debt and the financing options available to them.
CRE loans are now increasingly issued by private credit funds, with banks and insurance companies providing financing by gaining exposure to senior positions in these CRE loans through the aforementioned range of financing structures. tailored, each offering distinctive advantages and disadvantages in terms of risk, taxation, and regulatory treatment. EU and UK securitization regulations and their US equivalents have added risk retention to the list of structuring considerations.
When structuring a leveraged transaction, deal teams can evaluate different structuring options in terms of the returns achievable through leverage, the control that private credit funds can retain vis-à-vis vis the leverage provider on the underlying CRE loan assets and whether the senior coin is also tradable with non-bank institutional investors (such as pension funds and insurance companies).
Throughout 2022, we have seen greater complexity with combined structures (such as repack-to-repo structures, repo-to-repack structures and repack-to-repo-to-private securitization structures) to optimize the aforementioned functionalities as well as to obtain the desired regulatory treatment. In addition to the regulatory capital treatment, key structural drivers of these transactions include maximizing tax efficiency and achieving the required accounting treatment under a fully cross-linked structure for the private credit fund sponsor. Where funding takes the form of a repack-to-repo structure, for example, leverage providers have shown a preference for cleared notes which are (at least in theory) more liquid and remortgagable, with a listing venue off EU for tickets preferred by private credit sponsors due to EU Market Abuse Regulation considerations.
While public debt capital markets largely stagnated in the second half of 2022, tailor-made private financing solutions remain particularly attractive. They also allow larger private credit funds to increase CRE lending ahead of an eventual return of longer-term public capital market financing solutions like CMBS (CMBS 2.0) or the vaunted European CRE CLO. In the near term, we expect more bespoke private structured credit solutions to continue to thrive given the disruption in public markets and the prohibitive costs, due diligence and timing considerations associated with structuring and the marketing of public CMBS 2.0 and CRE CLOs.
Current market conditions raise important questions regarding fluctuations in both the cost of borrowing and the valuation of CRE’s underlying assets. Such market movements can trigger funding shortfalls, particularly when banks use margin calls to demand partial redemption to offset significant declines in the market value of underlying CRE assets. The prospect of a margin call with one or two business days’ notice is particularly unattractive to small private credit funds which, in the absence of a capital call from fund sponsors (which may take up to 10 business days), may not have access to other lines of funding or the option to voluntarily deleverage the facility to avoid the margin call and therefore could be easy prey for back leverage providers in the event of a market downturn.
In the eyes of private credit funds, the mark-to-market provisions in CRE’s leverage back facilities are fundamentally unfair, as these provisions borrow from technology used in liquid repo markets where pricing sources and reference points are well defined and generally readily available. Applying a variation of this methodology where the asset subject to the mark is (or is backed by) a single, illiquid asset may, if not traded well, grant undue discretion to the leverage provider back and an imbalance in the loans and the structural protections granted for them. These same imbalances can trigger liquidity problems for private credit funds, which will have to find other ways to inject the necessary liquidity.
Despite these additional challenges, our experiences with market participants suggest that the benefits of achieving healthy returns (for both parties) and favorable regulatory capital treatment (for bank lenders) are likely to continue to outweigh the plague of rising borrowing costs and additional liquidity considerations. While market participants may structure deals with lower overall leverage levels, thereby seeking to balance the concerns of lenders and credit funds, return leverage – in its various forms and variations – is likely to remain. an effective way for private credit funds to improve returns and increase market share.
