Real estate debt – a window of opportunity in 2023?

After years of strong growth for the majority of UK real estate sectors, the market is in the midst of a correction.

Having peaked in June 2022, valuations have fallen 20% over the second half of 2022. The key drivers are higher interest rates, general market volatility and the economic slowdown.

On an all-property level, forecasters suggest a 15-30% average fall in UK commercial property values from the June 2022 peak to 2023-2024. As of January 2023, market participants are expecting some further declines. However, this will depend on the circumstances of each asset, sub-sector and investor.

By comparison to peak and trough shocks, the global financial crisis market correction reflected a reduction of around 35% to property values, and the correction in the early 1990s saw a fall of around 30%.

Notwithstanding asset value declines, we continue to be supportive of lending against good quality assets. Structural trends still support strong demand for industrials and logistics, student accommodation, alternatives and residential assets. The occupier market in these sub-sectors was stable during 2022.

Debate about the future of the office is ongoing, but high quality, sustainable and well-located office buildings are still sought after.

Where could opportunities arise?

Investment grade real estate senior non-recourse debt targeting a loan to value (LTV) of up to 55% is currently expected to yield around 5-6% per annum, which in our view offers attractive return potential. We see two main areas for real estate debt opportunities:

• Financing new acquisitions. We expect more buying activity from opportunistic investors seeking to take advantage of the market correction. Debt investors can lend against lower valuations with the aim to reduce their risk if, as expected, the real estate market recovers from 2024 onwards.
• Supporting borrowers at refinancing. Higher interest rates and lower valuations mean that borrowers will likely require equity paydown at refinancing in 2023 and 2024 or seek higher LTV debt solutions to ensure orderly refinancing.

Timing and quality are everything

In our view, the dip in the UK real estate market will prove temporary and performance should improve from 2024 onwards. Our key focus areas going forward will be health of the UK economy, consumer affordability and occupational market performance; we are yet to see the full impact of tighter monetary policy and its knock-on effects to consumers and businesses. Weaker economic performance could negatively affect the real estate market further.

Underlying credit quality is of utmost importance as we are not out the woods yet. As such we target well-capitalised borrowers and property assets with strong fundamentals.

We believe there is now a window in which investors can seek to take advantage of reduced valuations and higher debt coupons on a five- to seven-year investment horizon while still taking a disciplined risk approach. This opportunity is likely to diminish once the market recovers, supply of financing increases and bond yields fall.

While market volatility rightly causes a lot of investors to pause for thought, our belief is that now is an appropriate time to consider the UK senior secured real estate debt market.