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Can going green accelerate European real estate debt’s bounce-back?

16 Nov 2023

War in Ukraine, rising inflation and skyrocketing interest rates have rocked the European commercial real estate market in the past two years. Thankfully, though, the dust is slowly beginning to settle and lenders and investors are adjusting to the new realities facing them.

Where previous crises led to waves of defaults, real estate debt funds are making more effort to avoid foreclosures in distressed portfolios in favour of refinancing. Instead of calling in loans or exiting an asset when there is a breach of covenant, property owners and fund managers are working together to put in more equity, if possible, and come up with a plan to repair covenants. Consequently, we are not seeing the defaults and foreclosures of the global financial crisis; an encouraging sign suggesting investors expect an upturn in the market before too long.

Furthermore, the switch to investing in Asia has been decisively reversed. In the last quarter of 2022, Asia-focused funds secured $6.1bn against $2.6bn for Europe-focused funds. In July, however, Savills noted that investment volumes in property across Asia were down 49% in the first half of the year. Earlier, Preqin had reported that in the first quarter of 2023, European funds raised $7.6bn against $2.9bn secured by Asia-focused funds.

Now that the European market seems to be returning to some sort of equilibrium, what should be on real estate investors’ minds? Top of the agenda must be the need for investment in reducing buildings’ energy use and carbon dioxide emissions, tying in with wider environmental, social and governance (ESG) priorities.

The ESG opportunity

ESG is stimulating investment across Europe, and decarbonisation in line with the Paris Agreement’s 2050 net zero target is providing opportunities for general partners (GPs).

The rise of green funds presents a number of benefits for GPs, investors and tenants alike. GPs that can show their projects have a positive social impact and enhance the environment will have an advantage in attracting capital from institutional investors that are setting net zero targets for portfolios. Additionally, tenants will have better quality buildings that fulfil their own carbon emissions reduction targets, and developers will find these properties easier to let than more energy-intensive buildings.

The hurdle of SFDR

That being said, there are some regulatory speedbumps that are stalling the growth of sustainable real estate development in Europe. The Sustainable Finance Disclosure Regulation (SFDR)’s taxonomy of sustainable economic activity does not classify renovating buildings as wholly sustainable. Investors will be less keen on investing in projects that are not aligned to the highest standards in the SFDR framework. This is unfortunate as 50% of existing buildings globally need to be net zero by 2040 to keep global warming to 1.5°C, according to the International Energy Agency.

An interesting aspect to note is that SFDR’s taxonomy does not properly take account of the additional CO2 output associated with newbuilds and its view of brown housing stock as merely ‘transitional’ is diverting investment away from it.

The European Public Real Estate Association has suggested the SFDR is reformed with simpler rules to stop its regulations from deterring investment.

Around 75% of EU building stock is energy inefficient, according to an M&G report, and the European Parliament wants all new builds to be zero emissions by 2028 and for existing buildings to be climate neutral by 2050. This will require another €275 billion a year of investment (on top of the current €85 million to €95 million), according to a Moody’s report. It will be even more difficult for the EU to achieve its climate objectives unless environmental regulation is reformed to make it more appealing to real estate investors.

The value of reputation, differentiation and communication

While there are high yields out there for real estate debt investors, securing capital to back these opportunities remains challenging. Rising costs, the unfavourable economic climate and the hugely ambitious climate targets mean the value of a GP’s reputation has never been higher when it comes to fundraising.

A good standing in the market will attract interest from new investors in this challenging environment and will help cement relationships with LPs from previous funds. A genuine commitment to ESG values, evidenced in previous deals, will reassure investors that want to be seen as doing the right thing and are incorporating increasingly stringent ESG criteria into due diligence processes.

A little unexpectedly given the mood of caution in the market, first-time funds are doing better than expected. But, on closer inspection, it becomes apparent that they often have highly seasoned teams, who bring significant transactional experience and longstanding relationships with existing investors with them.

Protracted fundraising across the market means competition for investor attention is putting further pressure on managers. This favours those with clearly differentiated strategies, as well as attractive fund terms that suit prospective investors.

In our view, GPs should communicate with investors frequently and in detail while fundraising to stay top-of-mind and highlight opportunities in an active deal pipeline. Fund managers’ transactional competence is coming under scrutiny in due diligence processes as value becomes harder to find, so detailed track records will be essential.

While recession fears, investor caution and higher interest rates and construction costs are creating challenges for the real estate debt market, the large amount of dry powder indicates that transaction volumes are set to increase in the coming year and diligent fund managers are most likely to find success by focusing on projects with ESG credentials and carefully chosen value-added and opportunistic assets with refurbishment costs that can be kept under control.

Speak to IQ-EQ

There are significant opportunities for investors in European private real estate and IQ-EQ’s team of experts can help new and established players make the most of these. Our expertise in areas such as investment fund structures, real estate finance, jurisdictions and operating models means managers can be confident that the administration of funds will run smoothly.

We help fund managers to reduce risks, improve their operations and add value for their investors. We enable our clients to focus their time and efforts on the core elements of their business: raising capital and deploying it in the best deals in terms of both environmental factors and commercial returns. Get in touch today to find out more.

Working with IQ-EQ has been seamless – you and your team understand our business, advise us appropriately, and handle your side of our collective partnership so that we can focus on making good investment decisions. Evan Gibson SVP, Merchants Capital

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