The dual funding gap: Debt cost and decarbonisation could see accelerated property sales
11 / 05 / 23 - 7 minute read
Real estate investors find themselves in a very different environment today than they have been in the last two decades.
While cheap debt fuelled much of the returns in the sector over the last 20 years, interest rates have risen sharply in recent years, while inflation is clocking in at levels not seen since the 1990s.
For investors, this means they can no longer rely on yield compression for returns as PATRIZIA states in a recent report titled Managing Real Estate in the New Norm.
Instead, they will need to refocus their attention on income. But in a world where inflation is high and recessions are looming in many parts of the world, it is a tricky balance to achieve income growth while maintaining rent affordability for tenants at the same time.
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Income resilience will be key in this new norm, says Mahdi Mokrane, Head of Global Investment Strategy, Research & Investment Solutions at PATRIZIA.
“Leveraged core is gone despite sound fundamentals in most markets, meaning that anything that uses high levels of leverage to acquire assets, we think, will be gone for quite some time,” he says. “This then means that the focus is going to be on income resilience. This means income that can genuinely offer inflation hedging.”
The next two years will be particularly challenging for many investors, as a large volume of transactions closed in the last 5-7 years will start coming up for refinancing. With debt today being much more expensive to service than in the past, this could push some investors to sell their assets, believes Mahdi.
“We think the market will see dislocation in some areas, particularly linked to two key factors,” Mahdi outlines. “One is debt refinancing. Many assets that were bought four or five years ago will have to be refinanced again and some of them will probably not be able to get the additional equity required to lower the LTV (loan-to-value ratio) in a world where interest rates are higher.
“The second is that a number of these assets will need capital expenditure (CAPEX) to remain relevant in the current context, so there will be opportunities in discounted core, because of the denominator effect in debt, as well as [the need for] value-add strategies.”
Mahdi says research indicates that in the UK alone, more than £60 billion of real estate debt will need to be refinanced over the next two years, while in the rest of Europe an even greater quantum is to be expected.
He continues: “Anything that was part of the last four, five, six years [of transactions] is coming up for refinancing and will have to do so in a very different environment. This will lead to [the emergence of] motivated sellers and we're already seeing signs of this.
“I'm not talking necessarily about full-fledged distress, but if you do some simple calculations and take an asset that had 60-65% leverage, then the banks will tell you that the value is probably 10-15% off and they are now only willing to lend only 50% of the value.
“Now, that requires a quantum of equity to be re-injected which is quite substantial.”
Data and research
Although the investment environment is much more challenging going forward, for those investors who have spent time and effort understanding their key tenant base, the upcoming volatility might provide some interesting opportunities.
But it requires a thorough understanding of tenants’ needs and demands and a repositioning of those assets that do not live up to modern standards.
“We really spent a lot of time understanding the location and how it relates to tenant demand,” Mahdi explains. “We use our Amenities Magnet 15 Minutes Report, which we developed for residential, but it also has a lot of relevance for offices.
“In this, we capture every single amenity that is in 10-15 minutes’ cycling or walking distance from an office asset that we are looking at repositioning, because there are clear correlations between the quality of those amenities and tenant demand.
“For example, we use the geocoded positioning of a bakery, kindergarten, restaurant, pub, doctor's surgery, or different types of retail. We capture all of that and we try to make sense of it and see how it correlates to demand, and ultimately to real estate performance, including rents, vacancy and speed of leasing.
“We’ve done a lot of work in residential, because in the past that is where we had the bulk of our portfolio. But we’ve expanded it now to a number of other commercial property types.
“But the amenities that matter for residential are not necessarily the same for offices. Some of them overlap, but many don’t. For example, the presence of restaurant and catering offerings is more important for offices than having retail offerings such as grocery stores.”
Sometimes the research finds gaps in the local offering of amenities and, in selected cases, PATRIZIA might decide to dedicate space within their assets to fill these gaps and open a day-care, retail offering or even a library in a building, for example.
To understand tenants’ needs fully, PATRIZIA has developed research capabilities that pull in data from not just traditional real estate metrics, but increasingly also from sources previously not considered. For example, the team looks at metrics such as air pollution and noise levels.
“Air quality or noise is relevant to offices, but is far more important for residential tenants,” Mahdi shares. “So we’ve designed those tools to cater for different needs and different property types.
“For example, more recently we’ve developed tools to measure the catchment area for urban and big box logistics. It’s a combination of the number of households in a given drive time, combined with their purchasing power. And we’ve developed a similar type of approach for retail.”
The models are continuously improved and increasingly incorporate data from new sources, including the ‘internet of things’ or buildings.
Mahdi explains: “We talk and engage with our tenants, and it’s this human interaction that enables us to better understand their current and future requirements and needs. But we can even go one step further and have our assets speak to us.
“The ‘internet of things’ is nothing other than putting in place systems that are not too costly and feed you with information about how a space is being used: what is the flow of tenants coming in and out of the building? What are the peak times? Which areas of the building are intensely used? And which areas of the building are neglected?
“In which areas of the building can you actually turn off the lights? In which areas do you not need heating? There are quite a number of initiatives that you can engage with to optimise the use of the building and its energy consumption.”
With an increased focus on the green credentials of buildings and a need to decarbonise assets, this data is becoming more important and Mahdi says the team is finding increasingly more areas that allow for improvements to be made.
“Our infrastructure teams put sensors in water systems in different cities and they have contracts with cities to identify leakages,” he says. “There are billions of gallons of water leaked every year, even in a country like the UK.
“You just realise how much you can save, because it takes a lot of energy, effort and cost to transform wastewater into drinkable water again.”
In 2020, PATRIZIA established its own smart-building technologies platform, which focuses solely on improving the efficiency of building systems, including heat, water, electricity and lighting systems. It also seeks to reduce waste and increase the efficiency of resource usage, including the use of water and gas.
“In many ways, you need to convince your tenants to ride with you on that journey and accept sharing information on the way they use their premises space to help them optimise the space, because, ultimately, if you help them make a saving, then that creates more willingness to pay for the space and the service that comes with it in the future,” says Mahdi.
Energy efficiency and decarbonisation
Decarbonisation and energy efficiency are not only driven by investors themselves, but European legislation is also pushing for tighter rules around energy efficiency in buildings.
At the end of 2021, a number of changes were introduced to the EU Energy Performance of Buildings Directive, which proposed that European Union member states introduce minimum energy performance standards by 2027. It also enshrined a definition of what zero-emission buildings look like.
If the changes to the directive are approved, then these new requirements will put additional requirements for CAPEX spend on investors.
“The CAPEX required to meet energy efficiency standards alone is enormous,” Mahdi shares. “We’re talking about potentially €7 trillion of retrofit in Europe alone for the whole built environment in the region.”
Although most of this will be spent on residential buildings, there is still a fair amount required to retrofit offices, logistics, retail and hotel buildings. In anticipation of stricter energy efficiency rules, certified green buildings have started to attract premiums, as Mahdi reveals.
“You now see increasing evidence of green premiums or brown discounts in the market,” he says.
“We have seen this both in our own portfolios and across the market, with premiums of up to 20-25% for green certified assets, particularly in the London office market but also in other markets such as Paris, Frankfurt and Berlin.
“That premium is great, because it enables you to better underwrite your CAPEX programmes, so value-add propositions are really going to be interesting as assets come to the market in the next few years.”
In the past, green premiums were not really priced into the market, but Mahdi sees more and more evidence of this during discussions with its lenders. PATRIZIA has a network of more than 240 lending relationships in Europe and questions are being raised on future green spending.
Mahdi says: “There is a pattern by which they now systematically ask: ‘What is your plan in terms of CAPEX and regulations? Do you have that priced? Do you have the right CAPEX quantum?”
Mahdi believes that this will only accelerate the decision to sell properties by investors who can’t or are not willing to spend the money to modernise their assets.
He says: “Many today that have to refinance and inject more equity just to cater for higher interest rates will look forward and say: ‘Well, I will also need to put in even more equity in the future to fund those CAPEX programmes’.
“The two combined – higher costs of debt and higher CAPEX to fund retrofits – may lead to decisions to simply just sell the asset now.”
The original article first appeared in i3. Click here to read this version.