• Gross margins rarely below 100 basis points - no further reduction of margins expected for 2015
   
• Year-end interest rates about one third of what they were at the start of the 2014
   
• Monetary environment more conservative than market perception would suggest

Seen in retrospect from a capital market point of view, 2014 was a rather unexciting year, as many of formerly hot topics such as the commitment of debt funds more or less fizzled out in Germany. This is the upshot of the latest Debt Advisory Market Insights published by the real estate consultancy firm CBRE. CBRE expects 2015 to bring an environment of historically low levels of interest, to see the bank refinancing market get back up to speed, and to deliver sound macroeconomic fundamentals. “Principally speaking, we see nothing but green lights for property investors and borrowers,” said Dirk Richolt, Head of Real Estate Finance at CBRE.

The 2014 Lending Market: Credit Spreads Stabilise on Low Level
In 2014, the lending market witnessed several large-scale transactions, and was defined by the open question – discussed mainly in the credit departments of financial institutes – of just how low the spreads might yet fall. As it turned out, however, gross margins (understood as reference above a given interest rate swap) rarely ever dipped below 100 basis points. “Based on the transactions concluded, we estimate that the lower limit is around 80 to 90 basis points,” said Richolt.

On the one hand, the extremely low base rates have more or less caused insurance companies and pension funds to pull out of lending. Different regulatory catalogues, more ample financial resources, and previously low exposure in this sector as far as margins go, gave them the financial leeway to quote more aggressive prices for the core assets they coveted. However, institutional lenders generally require an absolute minimum interest rate of 2.5 percent to 3 percent per annum, and currently get these only for maturities or fixed-interest periods in excess of ten years.

On the other hand, banks experienced a short-term trend reversal for their own refinancing costs during Q3. The CBRE Refinancing Cost Indicator for average credit risks, which reflects credit spreads from the money market and CDS market for senior and subordinated bank debt in addition to the terms of covered bond, showed a rather steady softening of the refinancing margin, from above 100 basis points in 2012 down to barely 40 basis points last summer. In October 2014, the volatility and the brief surge in risk aversion on the capital markets caused the indicator to climb up to 50 basis points. “While the margin did drop back to around 41 basis points by the end of the year, an analysis of each component of our approximated refinance mix returned an interesting shift,” explained Richolt. “Even though the mortgage bond and money market spreads have dropped to new lows, the trend is largely compensated by the increased costs of subordinated debt risks that are the direct result of a risen volatility and a slightly increased risk aversion.”

This makes it reasonable to predict that margins in senior real estate financing will not soften any further in the coming months, while the trend toward a higher risk tolerance on the part of the banks that manifests itself in loan components above the cover limit is likely to slow.

Interest Rate Development: Swap Rates Drop by Two Thirds
The development of interest rates in the course of 2014 must be rated as a historic first in every sense, and certainly ended the year a far cry from what had been predicted at its outset. Having started into the year on an anyway very low level of, e.g., 0.73 percent to 2.16 percent for three- to ten-year fixed-rate debt, the rates dropped to around one third of the initial level in the course of twelve months. Today, three- and ten-year interest rate contracts stand at 0.24 percent and 0.87 percent p.a., respectively.

“Even if you wanted to take out cover for ten-year interest rate hedges expiring two years from now, you would pay for such a forward interest rate hedge only half of what you would have paid in early 2014 for a regular, immediately effective ten-year fixing,” as Richolt elaborated. “The positive effect on the leveraged equity yield rate and the debt service coverage ratio is significant.” Today's lending rates are generally down to 1.5 to 2.0 percent, which means that if you assume a relatively constant property return of around 5 percent you will in many cases be able to sustain void costs and rent losses of up to 50 percent before your loan becomes distressed.

Money Supply Grows at Slower Rate than in Previous Decades
“One of the gravest concerns among investors – especially among German investors – have always been the negative ramifications of the aggressive monetary policy and the liquidity glut presumably created by the financial aid for banks and by the bond-buying programs,” said Richolt. “If, however, you take a look of the European Central Bank's financial statements for the past few years, you will note that its financial position has actually shrunk by one third and returned to the level of 2010.” This means it has already phased out the hazardous bailout policy to a large degree. Analogously, the money supply – in terms of the M3 measure – has grown at a noticeably slower rate than it did in previous decades. Since 2010, the sum total of central bank money, cash deposits and fixed-term deposits has only increased by anywhere between 0 and 4 percent annually. This should alleviate concerns regarding monetary stability and an irrational flight to tangible assets.

These basic facts are not directly qualified by the announcement of the ECB's bond-buying program to the tune of 60 billion euros per month – which will probably include approximately 45 billion euros in government bonds and the rest in agency/supranational bonds and covered bonds/ABS – through September 2016. Adding up to a grand total of more than 1.1 trillion euros, this equals more or less the amount by which the central bank balance sheet dropped over the past two years or ten percent of the current M3 money supply. The process therefore implies that expired liquidity infusions for banks are being shifted, mainly into government bonds. While we do not expect this to have a positive impact on inflation rates, we see a looming threat of potential asset price bubbles that could form on bond markets. Unsurprisingly, the rate for ten-year interest rate swaps slipped by another 10 basis points to 0.72 percent within minutes of the ECB's announcement of its quantitative easing policy. “Due to the crowding-out effect that is generated on the bond markets by the central banks of the Euro system, we expect institutional investors to speed up their portfolio reshuffling in favour of equities and property,” commented Richolt. “Against the background of an anyway rather wide yield spread of about 400 basis points between property investments and German Bunds, e.g. for Core office properties, and with a view to the negative interest difference between German interest titles, and long-term US treasury bonds / UK gilts, we expect the influx of institutional investors from inside Germany as well as from the Anglo-Saxon and Asian regions to increase considerably yet.”

Contact:

Dirk Richolt
CBRE GmbH
Head of Real Estate Finance Germany
+49 69 17 00 77 628
dirk.richolt@cbre.com

Dr. Jan Linsin
CBRE GmbH
Head of Research Germany
+49 69 17 00 77 663
jan.linsin@cbre.com