Financing Market

With inflation ostensibly under control and the ECB gradually looking ahead to a possible fall in interest rates, the mood regarding interest rates in the market is changing. The five-year IRS swap interest rate averaged 3.11% in 2023, and interest rate volatility decreased month-on-month over the course of the year. Having said that, since we are now witnessing a clear fall in inflation rates, the capital market interest rate is dipping too. The five-year IRS swap interest rate fell by 100 basis points between mid-October and mid-December 2023. The interest rate is currently stabilising at a considerably lower level, namely between 2.4% and 2.5%.

This is a significant change compared to the beginning of autumn 2023, when the five-year IRS swap rate peaked at 3.5%. A sharp drop in the three-month Euribor rate is therefore expected in the foreseeable future.

It is still sitting at 3.9% as it stands now, and should fall to 2.4% by one year’s time, based on the current level of the five-year IRS swap rate. This is a huge drop given the unpredictable geopolitical and economic developments across the world. Partly for this reason, current real estate financing rates are quite attractive, especially considering that the likelihood of even lower interest rates is slim.

Fall in interest rates will expedite price equilibrium in the real estate market

Whereas CBRE had previously assumed a slight depreciation of real estate, this now seems to be largely offset by significantly lower interest rates. It should be noted, however, that there may still be smoothing in valuations, where the appraised value is still lagging behind the actual market price. Still, lower interest rates are welcome, and may help rebalance real estate market pricing sooner.

The fall in rates is partly driven by the drop in inflation, but mainly by expectations that the ECB’s interest rate policy will also be adjusted downwards going forward. The market seems to be assuming a phased decline of 50 basis points, after which, in the years that follow, the ECB will return the interest rate to the level just above 2% by 2027. However, this expectation largely depends on movements in core inflation, the economic situation in Europe and the capacity for refinancing countries’ debt.

Rising refinancing challenges, despite falling interest rates

With interest rates falling and the likelihood of them stabilising over the rest of the year, there will be more clarity on the current pricing and exit yields in the real estate market. This ensures that investment decisions for acquisitions and dispositions, as well as investments in renovation will be made with more certainty. This in turn will have a positive impact on the dynamics of the real estate market.

Despite falling interest rates affecting real estate market dynamics positively, we will still have to deal with the aftermath of higher interest rates – combined with a fall in real estate values and tighter financing policies – in the coming years. Given that taking on five-year financing is par for the course, many investments made between 2019 and 2022 will be eligible for refinancing in the near future.

This means that investors will be confronted with a combination of changes. Not only will the interest rate be about 250 to 300 basis points higher than it was when the loan was originally taken out, the value of the real estate has also fallen sharply. Added to this, financiers have adjusted their financing policies down the years. First and foremost, the loan-to-value (LTV) ratio has fallen because the risks are lower. This ratio sat at around 60% in 2019; it has subsequently fallen to under 55%. What is more, financiers are being more tactical when it comes to taking on funding or continuing with existing financing. There is more focus on the clients with whom the financing relationship will be continued and/or expanded, and how the real estate financing portfolio can be recalibrated according to the sector, given the change in market risks. In practice, this mainly means a shift towards financing housing and logistics, and less propensity to finance offices and retail space.

All things considered, the trends and developments mentioned above are creating a funding gap in the financing market. This means that some of the existing loans cannot be refinanced with the financier where they are being held given the current conditions and the new financing policies.

The refinancing challenge is mainly down to the combined impact of a fall in value and the LTV funding policy. Based on these developments, the primary refinancing challenges are being felt in the office space and retail markets. Not only did capital value decline the most between 2019 and now, the LTV policy also sustained the most severe downward adjustment in these sectors.

This challenge seems to be considerably smaller in the logistics market and – to a lesser extent – in the residential market. This is primarily due to the fact that capital values rose considerably in these sectors between 2019 and now. Added to this, the financiers’ liquidity is focusing more on these sectors, the LTV is less stringent and future prospects are more favourable. Because of this, refinancing problems have had a relatively minor impact in these sectors.

The refinancing issues in the housing market are mainly affecting real estate development projects; this is hardly the case for existing residential complexes. For logistics, the refinancing issue is evidently limited to a few purchases made based on maximum financing at the time the market peaked (early 2022).

Refinancing gap of €5.2 billion: mainly in 2024 with the focus on offices

Higher interest rates, adjusted financing policies and a decline in real estate values suggest that there will be a refinancing gap of about €5.2 billion in the Netherlands, spread over the next four years. Of this refinancing gap, 61% relates to office real estate. The remainder is modelled for retail (20.2%) and residential (13.6%) real estate. Only 4.5% of the financing gap relates to logistics or industrial real estate.

The majority of refinancing challenges will be faced in the coming year. Given the current financing policies and the value of the real estate, there is a deficit of about €2.6 billion. This does not imply that this real estate will actually have to be sold. Indeed, with many of these properties, cash flow is still good, given the very low vacancy rates in all types of occupier markets. The upshot of this is that financiers are generally willing to look for other solutions.

Yet owners usually look to sell the building first, partly because the initial investment horizon is nearing its end, or because the risk ratings or requirements for returns no longer fit within the fund strategy. After an informal market review, it becomes clear to them to what extent and at what price there is sufficient liquidity to take over the building. Often this information persuades them to reconsider the option of resorting to refinancing.

The extent to which refinancing can be successfully concluded then depends on:

1. the degree to which the owner is in a position to contribute capital;
2. the level of the current LTV ratio;
3. the extent to which the financier is willing to be flexible when it comes to finding a solution.

To date, CBRE has witnessed the majority of owners opting for refinancing, except when the situation is so difficult that selling appears to be the only way out.

Even if the LTV ratio is too high, there are always refinancing options, provided they are in keeping with the interest coverage ratio

If the owner proceeds to refinancing, the path to the existing funder remains the most attractive by far. In the process, the owner will have to convince the financier that refinancing is necessary, and this will have to be done transparently – particularly given that it often goes against the financier’s prevailing financing policy. At the same time, a solution will have to be found, based on a comprehensive review of the business plan, which must include potential exit strategies.

ESG plays a crucial role when it comes to persuading financiers. Besides laws and regulations, financiers are very well aware that a good and quantitatively measurable ESG strategy enhances rental income and awakens investor interest. This reduces refinancing risks when their investments mature. This may persuade a financier to proceed with refinancing that – to all intents and purposes – flies in the face of their financing policies.

A sound, revised business plan does not automatically imply that the financing will be extended. What is more: many financiers are extremely reticent when first approached about refinancing. If additional capital cannot be contributed to lower the LTV ratio, the solution often has to be found in refinancing, which may include token direct repayments, periodic cash sweep repayments and at a higher margin. This is to compensate for an LTV ratio that is too high in comparison with the financier’s standard policies. The upshot is that the owner will have little or no cash flow from the real estate. The market will accept a higher LTV ratio subject to these conditions, as long as the ratio stays within the affordability range (capped at 1.2/1.3 of the interest coverage ratio) and there is scope for the mandatory repayment to reduce the LTV ratio, and with that, the risk going forward.

There are alternatives, but they are significantly more expensive. Take, for instance, a combination of a non-subordinated loan with the main lender and a subordinated loan, or a whole loan solution: higher LTV financing from a more opportunistic, and therefore more expensive, lender.

Both combinations may present a solution if the principal financier is not sufficiently flexible, but, fundamentally, both alternatives are a lot more expensive. Added to this, principal financiers do not always agree to taking on a subordinated loan because it complicates matters considerably. If an additional subordinated loan is involved, the principal financier cannot independently address any problems with the real estate client. Moreover, the principal financier may have to discuss matters with the second financier if the latter takes over the shares, which makes the situation a lot more complicated. Quite part from that, this kind of construction often leads to a significantly tighter interest coverage ratio, which can ultimately lead to rating problems with the principal financier.

Despite the sizable hypothetical funding gap, in practice there are plenty of opportunities to close this gap in refinancing. Moreover, refinancing seems likely to pay off in the short and medium term. There are several reasons for this:

1. A short-term renewal of between two to three years may in due course lead to slightly lower interest rates and hence better pricing and liquidity in the market.
2. Borrowers stand to benefit from indexation going forward, which may boost the value.
3. There is time to work out an asset management strategy for a few years hence, when the time to exit is more appropriate.
4. The investment market – especially when it comes to larger transaction volumes – will be more liquid in the medium term than as it stands now.

Limited capacity to fund new builds is pushing developers towards joint ventures

Apart from refinancing, financing projects, particularly housing developments, is still a challenge in the prevailing market. The sharply reduced value – which is even more pronounced in land values – is having a significant impact on potential profits from projects, and exposes financiers to additional risks. Because of this, a loan-to-gross-development value (LTGDV) that is acceptable to the financier lowers the loan-to-cost (LTC) ratio Many developers believe forward purchasing is a solution to this, but in practice this produces a fractional change in the LTC. The main thrust here is that more of the borrower’s own money has to be contributed in the initial stages of the project before it can start.

This situation, combined with increased reticence on the part of investors when it involves forward funding transactions, means that property developers are increasingly looking for a joint venture setup.

That is one way to raise the right amount of equity to be able to start projects. All things taken into consideration, this obviously delays the launching of new-build projects, particularly when several new construction projects are stated at the same time. After all, equity can only be used selectively on a few projects.