Deleveraging in focus: waiting for cost of capital to stabilise

The Nordic real estate market, and in particular the Swedish real estate market, is dominated by private and institutional/government owned real estate companies. Listed and institutional/government owned real estate companies in the Nordics have increased their exposure to the bond market. They operate with higher LTV and net debt earnings before interest, taxes, depreciation and amortisation (ND/EBITDA) multiples, compared with their peers in both Europe and the US. Financial leverage; however, needs to be adjusted for institutional and government-backed bond maturities which exaggerate the perceived outstanding risks, since the market for higher rated bonds is still active. is clear that both the listed sector and funds need more equity when refinancing debt, given the current higher level of funding costs. This acts negatively for the transactions market in the short to mediumterm although it may trigger mergers and acquisitions (M&A) if the cost of capital stabilises towards the end of 2023 and into 2024. Key differences with the US market relates to concentration risk in both banks and bond market exposure. Outlook from US capital market has rebounded in the last month which bodes well for a rebound to support the Nordic bond market also. Combination with better access to capital, slightly lower spreads and more equity initially create basis for a turn in the market over the coming years.

Nordics: Higher leverage acts negatively

The Nordic real estate market, and in particular the Swedish real estate market, has expanded debt sharply, with gross debt of SEK 1,521 billion (made up of SEK 826 billion from listed equity and SEK 695 billion from institutional / government owned real estate companies). This total has risen eightfold since 2010, of which a substantial part relates to outstanding bonds (an estimated 46 percent as of the third quarter of 2022). A lack of liquidity in the investment grade and high yield bond market, in combination with a sharp increase in base interest rates, has caused regulators and financial institutions to raise concerns regarding refinancing risks.

Performance among the Nordic listed sector was strong up until 2021, with a compound annual growth rate (CAGR) of 23 percent per year, over the last five years, which was 5 percent better than all the companies on the Nordic index. Over this period, the sector had been trading in line with its net asset value (NAV), although towards the end of 2021 the sector was trading on 23 percent premium to NAV (median). The sector expected returns stood strong owing to the low interest rate environment, which elevated the valuation downside risks. During 2022, the sector equity index declined by 43 percent and underperformed the general market by 31 percent, which implies that the five-year CAGR outperformance turned to a negative 1 percent. Some higher levered companies (at the end of 2021) were down by up to 80 percent in the year, and the sector ended 2022 trading close to 40 percent median discount to NAV, substantially lower than the 23 percent premium seen early 2021*.

The financial risks among listed real estate companies have fallen sharply since 2009, with a median LTV of 48 percent, compared with 60 percent previously. However, from an income point of view, the ND/ EBITDA (net operating income less central costs) of today’s lower yields implies substantially higher multiples of 12.5 times EBITDA in relation to ND, which is well above 9.6 times EBITDA seen in 2009, despite a lower LTV. When broadening the exposure to all of the listed real estate companies today, both LTV and ND/EBITDA are higher. This is due to the listing of predominantly residential related companies since 2019 bearing higher financial leverage, albeit with lower operational risky assets and, hence, lower yields than the overall market.

ND/EBITDA (Annualised Quarterly) support very high credit ratings and, despite turbulence in the bond market, these institutions have been able to continue to tap the market during 2022, with volumed issues of SEK 35.2 billion. institutional/government owned real estate companies have expanded sharply over the last five years, growing the portfolio predominantly within the low-risk residential segment, and with funding linked to the bond market.

Companies ND/EBITDA (Annualised Quarterly)

Mitigating factors supporting the strength of A- rated companies

• Institutional/Government owned real estate A- rated companies can still access the bond market and issued bonds for more than SEK 32 billions in 2022, which limits refinancing risks for the sector. • LTV and ND/EBITDA multiples are higher within institutional/government owned real estate companies compared with the listed Nordic companies.

Institutional/government owned real estate companies today use the bond market as a main source of finance, which elevates the exposure but not the refinancing risks to the same extent. Institutional/government owned real estate companies today stand for 46 percent of the outstanding bonds maturing in 2023–2026 and SEK 182 billion in volume. These are dominated by Swedish companies: Heimstaden Bostad, Vasakronan, Akademiska hus, Specialfastigheter, Hemsö and Willhem, which are all backed by pension funds: AP funds, Alecta and Folksam or the Government owned: Specialfastigheter and Akademiska Hus. High-quality assets, in combination with strong ownership,

Listed sector volatility is the limiting factor for the direct market in 2022/2023

Listed companies have represented up to 70 percent of the transaction volume in the direct market in Sweden over the last four years, when we include M&A and entity deals while during 2022, the share dropped to 35 percent in Sweden. The sharp increase in funding costs and delayed impact on reported values, in combination with elevated financial risk among some listed companies, has clearly limited transaction volume in 2022, with a risk of continuation in 2023. Lower liquidity in the transaction market is among the factors that rating agencies, banks and bond market participants consider and could trigger a negative spiral of events, which could put further pressure on the cost of capital.

The starting point for liquidity in the Nordic market remains strong, with the Nordic transactions market representing 2.5 percent of GDP during the last five years, compared with 1.9 percent among developed markets. This represents a close to 40 percent higher transactions volume relative to GDP. During years with lower activity, i.e., 2008–2009, 2016 and in 2020, transactions volumes relative to GDP were, on average, 125 percent higher than the developed countries and had relatively stronger relationships than on average.

A temporary normalisation on the lower level should likely not trigger negative events, although in the longer term the liquidity needs to be sustained. Given the negative outlook on the overall economy, in combination with further increases in short interest rates, there is clearly a need for new equity or dilutive effects to NAV, priced in by the market in general.

Transaction Market Compared with GDP (excluding entity/M&A transactions)

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The need for more equity could also trigger M&A and buy out from the market, although, in the short term, both spin-off, noncash issues and consolidations with credit supportive drivers could elevate total liquidity. The lack of transparency within these structural events might; however, limit read across the market (for example, evidence for valuators). Therefore, there is a need to be clearly positive from a creditor/bank perspective in order to be motivated. Short-term covenants related to interest coverage ratios (ICR) and, to a lesser extent in the Nordics, ND/EBITDA will be an important driver for capital injections and/or divestments. High loan to values could also act as a negative driver for companies with secured interest and capital duration. This will be mostly related to rated companies in which rating agencies take a more negative view on asset decline in the estimates.

European Lender Appetite and Allocations Spectrum

Banks

Many banks are currently preoccupied with managing their existing loanbooks, in particular, resolving bad loans.There are also increasing pressures to the regulatory capital from 1 January 2023, including the mandatory implementation of certain Basel III and IV requirements.

Investment Banks

The recent significant reduction in syndication and securitised liquidity has left many investment banks with large unsyndicated loans sitting on their balance sheets. This has restricted their ability to allocate capital for new loans, particularly for larger transactions.

Insurance Companies

Insurance companies vary in their 2023 real estate lending allocations. Some have increased appetites for mortgages, whilst others have reduced allocations. Overall, this puts the insurer cohort as net neutral, in terms of where they sit in the appetite and allocations spectrum.

Other considerations

Leverage

Increasing lender scrutiny on the portfolio’s existing ESG credentials and, importantly, the go forward business plan, will further futureproof the assets from a sustainability perspective.

Debt Funds

Increases to the underlying indices have improved the returns achievable through the debt component of the capital stack. This has generated higher allocations from fund LPs to private equity debt funds, and has also made it possible for these vehicles to achieve their target returns without utilising large amounts of back-leverage.

Pension Funds & SWFs

Traditionally, pension funds and Sovereign Wealth Funds target equity opportunities. However, with attractive risk adjusted returns in the credit space these groups have increased their allocations to the real estate debt positions. They often focus on writing large loans, so will therefore be a natural fit for this project.

Global Funding

Markets are about to

Stabilise We are catching Michael Kavanau Chairman EMEA Debt Advisory and Senior Managing Director with JLL US Capital Market between meetings at JLL Global Credit conference hosting +500 specialists in Florida US.

Editor: What are the main global trends within financing post covid and in the current higher interest rate environment?

Michael: There are some historical elements that match over in terms of some of the main global trends post COVID and the higher interest rate environment. However, the main issue is that unlike prior recessions or exogenous crises, there's still a lot of liquidity in the system, and in fact more liquidity coming into the credit system everyday. Although investors don't have conviction about buying real estate because they're not sure how you underwrite inflation versus recession there's just so many variables that it makes it very hard to make a convicted equity bet. But investors have a lot of money, and they need to make returns, so we're seeing them move almost completely into credit investments.

Editor: Current higher interest rate environment, what happens from a debt market perspective?

Michael: For several years we had zero and negative interest rates and tight credit spreads, so projects were bought in the two and four percent yield range. They were financed in the one to three percent interest rate environment and now we have the risk-free rate in the US at around 3.75 percent. So it's a pretty big shock to the system across the globe. We have found historically that the loans that get made in these times of uncertainty do come with more structure and sometimes slightly higher pricing and generally higher returns overall, mainly since the underlying risk-free index is higher and investors will likely look back in a few years and recognise that these are the best loans that they've made in a very long time.

Editor: Which are the main differences between US, Europe and the Nordics

Michael: In terms of the main differences between the US and the Nordics, the Nordics are reliant historically on the public bond market and focused on a few local banks with less alternatives as seen in the US credit market – and in the past several years there’s been a significant diversification in lendin sources in the U.K. and Euorpe. In the Nordics it's a concentration risk and that explains a lot of negative movements we're seeing right now. The other thing relates to the corporate bond market we had seen spreads widen out, but lately they’ve come in between 45 and 55 basis points over the last 45 days in the US. So hopefully that's a good sign for the market starting to believe that we're turning down again also in Europe and in the Nordic credit spreads.

Editor: What do you think will drive the financing markets in 2023?

Michael: The outlook will be related to stabilisation of the short term rates and likely clarity depending on if we hit a soft landing or we have a recession. Regardless, given the liquidity, the likely outcome should not be terrible and we're either already entered it or will soon enter it and likely come out quickly. There is some optimism in that the corporate bond market nearly immediately flows through to credit spreads in the secured market, i.e. supported by the banks and insurance companies. This would create the potential for a quick flow through to the credit spreads and or the availability of Corporate debt bonds in in the Nordics. The current view is that this would enable transactions which are starting to happen. The World's functioning again, it's not just lenders trying to exit deals. It's money coming in.