European banks’ colossal €600bn five-year commercial real estate (CRE) deleveraging cycle will prompt cherry-picking buys worth around €100bn from US private equity funds, REITs and banks, predicts Morgan Stanley.
The scale of European bank deleveraging is likely to be double the $380bn stated by the banks themselves in a self-confessed “cautious” assessment of the next five years. The figure comprises $525bn of European CRE loans and a further $50bn in US CRE loans, held by European banks.
Morgan Stanley’s estimated €100bn participation by US private equity funds, REITs, banks and life insurers is composed of: a combined $50bn investment by private equity funds and REITs, the majority of the $50bn outstanding exposure by European banks to US CRE loans, with the balance in additional cherry picking of loan and direct CRE exposure by banks and life insurers.
US banks’ selective appetite
Morgan Stanley argues in a comprehensive analysis of US lenders and investors’ appetite for and ability to exploit Europe’s enormous deleveraging cycle that US banks have more than enough capacity to absorb European banks’ estimated $50bn in US CRE loans, given their strong capital ratios, capital generation and excess liquidity.
But they are only likely to want some of the total exposure.
Wells Fargo and JPMorgan Chase are cited as the two banks with greatest capacity and likely appetite to absorb US CRE loans by exiting European banks, following their purchase of part of the giant $9.65bn Anglo Irish Bank US loan portfolio last August.
Wells bought two pools of predominantly performing loans with a face value of between $3bn and $3.5bn, at a less than 20% discount, while JPMorgan won the best performing loan pool of the giant loan portfolio’s eight pools, with a book value of between $1bn and $1.5bn.
Bank of America Merrill Lynch (BAML), in a few years’ time, is thought to be another possible interested buyer, but Morgan Stanley estimates that capacity does not currently exist. Citigroup is discounted as a potential accumulator of CRE market share, given its real estate loan portfolio sale to JPMorgan two years ago, and a wider bank focus on Latin America and Asian consumer markets.
“Given US banks’ high capital and liquidity, and their desire to put money to work, we believe terms and pricing in the segment for small to moderate sized loans, below $30m, in particular are likely to become more competitive as this is a sweet spot for midcap and large cap banks,” wrote Morgan Stanley in its latest Blue Paper investment note, entitled EU Shakes, US Selectively Takes.
But little interest is expected to emerge from US banks in European CRE loans or direct properties because “US banks just aren’t big enough in European CRE”.
The report stated: “Most don’t have a sufficient portfolio to integrate one-off CRE loans. Interest in these EU loans is more likely to come from private equity funds, select US REITs and alternative EU funding.”
US private equity funds are Europe’s white knights
US private equity has an estimated $127bn of uninvested raised capital – known as “dry powder” – which will be deployed across US and European CRE markets, through loan portfolios and direct portfolios.
The proportion of dry powder destined for Europe is increasing, with around 20% of last year’s $54bn global private equity real estate capital raising targeting the Continent – up from a 12% proportion in 2010, according to Prequin. Interest in Europe looks set to grow again this year, with 33% of limited partners (LPs) surveyed by Preqin planning to allocate to Europe.
Blackstone, with $48bn in assets under management including $13.3bn of dry powder, is the standout best-placed private equity player to benefit from dislocation in global real estate, particularly in larger-scale equity deals, argues Morgan Stanley.
“Other private equity players are trying to catch up to Blackstone, but this takes time as strong track records must be established prior to raising sizeable funds.”
Global private equity real estate funds have a combined $159bn in dry powder, according to Morgan Stanley’s research. Based on Prequin’s 2011 20% allocation to Europe, would imply $31.8bn, with the actual amount invested possibly larger still assuming LP’s geographical allocations to Europe have risen since last year’s levels.
Blackstone is out in front with $13.3bn in dry powder, after which the next eight comprise: Lone Star Funds, with $8.4bn; Goldman Sachs Merchant Banking Division, with $3.0bn; Angelo, Gordon & Co, with $2.6bn; Beacon Capital Partners, with $2.5bn; Cornerstone Real Estate Advisers, with $2.2bn; AXA Real Estate, with $2.2bn; Westbrook Partners, with $2.0bn; and Starwood Capital Group, also with $2.0bn.
US REITs could invest around $15bn in Europe
Morgan Stanley estimates US REITs, after spending more than $200bn in the 2003 to 2007 cycle in commercial real estate, has the capacity to absorb up to $150bn over the next five-year cycle, based on the REIT industry’s historical track record of acquisitions and equity capital-raising.
Blue-chip US REITs with a global focus, robust access to capital markets and strong balance sheets are well-positioned and likely to be willing to acquire European CRE assets through the deleveraging cycle.
Simon Property, Boston Properties, Brookfield, Digital Realty and Public Storage are tipped as probable meaningful European CRE investors on this analysis.
Simon’s recent purchase of a 29% stake in Klepierre, a French mall REIT, is a case in point. Simon financed the acquisition in conjunction with a US portfolio purchase, raising a total of $3.1bn in debt and equity, including accessing the unsecured debt market at a blended yield of 3.4% over a 15-year term.
Morgan Stanley wrote: “As the result of favourable financing, the acquisitions were immediately accretive and management increased 2012 earnings guidance by 2%. Simon was able to take advantage of its valuation premium to buy Klepierre, which was trading at a discount, and we would not be surprised to see our potential buyers cohort follow a similar path.”
Assuming these REITs were to expand their portfolio over the next five years by 10% (of their current enterprise value), Morgan Stanley estimates future European acquisitions worth around $15bn.
By contrast, most quoted European property companies and most unlisted property funds are unlikely to emerge as meaningful competitors at the bidding table given their current focus on deleveraging, argues Morgan Stanley.
But sovereign wealth funds are allocating more funds to European commercial property at the prime end while German quoted property companies are also expected to remain net investors over the coming cycle. US REITs, therefore, will likely find less competition in the B to A- property-quality segment, suggests Morgan Stanley.
Stability in the US capital markets may allow incremental risk-taking in Europe. US REITs have had the tailwind of liquid equity and debt markets to help maintain valuation levels. US REITs have historically traded at a premium to European P/NAVs, which has widened significantly since the market bottom in 2009.
US insurers will be modest participators
Morgan Stanley estimates life insurers have the capacity to increase CRE loans by $25bn to $75bn, with a base scenario of around $45bn, fuelled by continued low interest rates should drive insurers’ appetite for CRE loans, which have more attractive yields than traditional fixed income investments (e.g., investment-grade bonds).
US life insurers are allowed to allocate up to between 40% and 50% of their investments to CRE loans. But for the most part these levels have been the exception rather than the rule, because they need to consider the correlation of investment values with liabilities, duration matching, and concentration risks.
MetLife and Prudential are tipped as the likely winners in Europe’s great deleveraging cycle, whose CRE loans as percentage of invested assets as at the first quarter of 2012 were 15% and 10%, respectively.
Morgan Stanley wrote: “We expect continued low interest rates to drive insurers’ appetite for CRE loans, which have more attractive yields than traditional fixed income investments (e.g., investment-grade bonds). We think insurers will be interested in large, high-quality CRE loans that become available in the US, but we do not see much interest in adding meaningful exposure to EU CRE loans.”
In March, Morgan Stanley wrote that Europe’s accelerating deleveraging in the €2.4trn real estate debt markets over the next three to five years will crystallise up to a €700bn financing gap, making ‘winners’ out of private equity giants Blackstone and Partners Group.