Buyers face a European investment dilemma

Investment into commercial real estate in the UK during the first half of this year was at its lowest in almost a decade – £19.7bn compared with £28.9bn a year ago, and 4% below the long-term average. Over the same period, total UK commercial property investment levels were around a third of last year’s total of £62.4bn. Why is this, when Brexit uncertainty and the political merry-go-round has driven the UK to its lowest interest rate environment in living memory, coupled with the availability of historically cheap debt? In my last column in April, I talked about how debt pricing was at an all-time low, how LIBOR had come down since the start of the year and how five-year swap rates were at 115 basis points. Four months later, and five-year swap rates are now hovering around 63bps. The Bank of England’s interest rate, at 0.75%, has remained unchanged since August 2018. As set out in the BoE’s May Inflation Report, the market-implied path for UK interest rates has fallen to about 1% by 2022, down from 1.50% in the February forecast. What does this mean for commercial real estate borrowers? Fundamentally it has reduced the overall cost of debt even further, and is therefore producing enhanced returns to cash-on-cash buyers looking to borrow in the UK. If debt is so cheap and interest rates historically low, why aren’t we seeing more investment activity in the market? While the all-in cost of borrowing may have come down, political uncertainty is deterring overseas capital from investing in UK commercial real estate; it is dominating investment decisions. Both borrowers and lenders share the same concerns around office take-up in the City of London. Serviced office providers – which lenders already approach with caution – are also coming under increased scrutiny. Sectors which haven’t yet felt an impact are those whose income profile is driven by sound underlying demographics, such as student accommodation, PRS and retirement living. So where to deploy the ‘wall of capital’ sitting and waiting on the sidelines? What we are seeing at Knight Frank is that many clients are looking for investment opportunities in Europe, specifically Spain, Germany, the Netherlands and Czech Republic. We have been engaging with local lenders on a regular basis, as well as debt funds and insurers whose remit extends across Europe, and so far, lender appetite has proven to be strong. This activity in Europe brings about a new and different set of challenges for our team. European lenders size their opening leverage off exit debt yields – net operating income divided by facility amount at the point of loan maturity. As more and more capital is attracted to European assets, it has led to prices rising, yet borrower’s loan-to-value requests remain at the same percentage levels. This has resulted in a lower debt yield, which is in turn limiting leverage. This means that it has become harder to source debt in line with borrower expectations, particularly for assets that are not considered prime.  We know there are a lot of investors who want to deploy capital into real estate. However, in the UK Brexit uncertainty is causing them to wait and see what happens on 31 October and in continental Europe, where real estate is expensive with reduced debt yields and lenders are restricted in the amount they can lend. This is the dilemma – and reality – that the European real estate investment market is facing today. Lisa Attenborough is head of Knight Frank Debt Advisory