Key highlights
With the exception of offices, the rebasing of real estate sector valuations has stabilised, leading to an attractive entry point - particularly for senior lenders.
- While 2023 deal flow was below long-term averages, many lenders found themselves navigating refinancing challenges and defaults in their existing portfolios. This led to lower LTVs (loan-to-values) and higher margins – a positive trend from our perspective, given that we had no issues across our portfolios.
- Corporate bond spreads continue to tighten. According to the BofA 3-5 Year Sterling Single A Corporate Index, the spread over gilts is currently 133 basis points (bps) compared with highs of 239bps in October 2022. As a result, illiquidity pickups of more than 200bps are currently achievable for similar-rated commercial real estate (CREL) deals (typical LTVs of between 40 and 45%).
- Total returns, margins and illiquidity pickups are now at some of the highest levels seen in the market for many years. Meanwhile, the rebasing of capital values and lower LTVs means the risk-adjusted return has rarely looked more compelling for commercial real estate debt.
Compelling returns?
As a result of the above changes, we think the market presents a strong opportunity for commercial real estate lenders, as you can see in Charts 1 and 2. With corrected values, we are now lending from a much lower base, more closely aligned to long-term average valuations. Due to lower levels of competition from lenders, LTVs are 10-15 percentage points lower than the peak of the market in 2022 (from on average 60% to 45-50%). Margins are higher (minimum of 15bps) and corporate bond spreads continue to tighten.
Chart 1: UK Property: Capital Value Returns by Sector since January 2022
Chart 2: European Property: Capital Value Returns by Sector since January 2022
Source: Green Street CPPI Indices, December 2023. Starting value 100 at 1 January 2022
Taking these factors into account, we believe commercial real estate debt can offer a compelling risk-adjusted return, delivering an illiquidity pickup of 150-200bps and total returns of 6-8% for investment grade debt.
Rate cuts could boost capital values
Last year was mixed for real estate equity and debt markets. Market uncertainty around capital values and interest rates resulted in lower transactional activity in equity markets. While refinancing requirements helped support deal flow in debt capital markets, this was also below longer-term trends.
The improving outlook for interest rates is expected to result in higher levels of transactional activity
Chart 3: UK 5-Year Gilt - abrdn Commercial Real Estate Lending Outlook
Source: Bloomberg 1st January 2024. For illustrative purposes only. No assumptions regarding future performance should be made.
We believe this increased transactional activity should lead to an increase in debt requirements in 2024. However, regardless of any acquisitions, the wall of refinancing requirements edges ever closer, which should further support significant deal flow in 2024.
The importance of lender liquidity
So, while the demand side of the equation is looking more and more positive, it is important to recognise the supply side, or lender liquidity, is likely to remain constrained throughout 2024. This plays strongly to our favour, ensuring we can remain highly selective, and with less competition, secure a better deal for our investors.
Liquidity levels in the market are lower
According to CBRE, approximately 25% of outstanding debt matures throughout 2024 and AEW estimates that the funding gap across Europe is approximately EUR90 billion. Many traditional lenders are struggling with defaults on their existing portfolios, particularly those who have lent against poorer quality offices. As a result, market liquidity levels are lower as these banks spend more of their time and capital trying to repair their balance sheets. For lenders such as abrdn, with zero defaults, an exceptional portfolio of existing investments and capital to deploy, this presents an attractive investment environment.
Capturing opportunity
2023 was another positive year for abrdn. We were able to secure a number of new transactions, delivering attractive returns for our investors. We completed seven transactions, totalling over £200 million, at a weighted average LTV of 43%, with an average rating of A, delivering an average margin of 307bps and an illiquidity pickup of 176bps.
We are anticipating a busy 2024 and are working closely with our investors, existing and new, to ensure we are ready to capture this compelling and evolving market opportunity.
As always in times of market change, discipline is key. abrdn is one of Europe’s largest real estate equity investors with a track record of investment across the UK and Europe. Our real estate expertise is fully hardwired into our real estate debt investment process, This key USP has ensured we have remained ahead of market developments. We aim to protect our investors’ capital and deliver robust returns without defaults or portfolio stress.
ESG impacts refinancing
Environmental, social and governance (ESG) factors are a core focus of almost all lenders now. ESG is affecting refinancing, especially in the office sector. We believe poorer quality assets without a clear sustainability transition plan in place will continue to struggle and face steeper declines in capital values. We have focused on sustainability within our underwriting and portfolio management process for many years with a clear focus on mitigating risk as well as recognising, through margin reductions, borrowers who make meaningful improvements to the sustainability of our secured assets over the loan term.
Key CREL themes
Here, we detail some of the key themes from our deployment and portfolio management initiatives in the past five years:
- We targeted the dislocation in retail market pricing by actively lending against high quality retail parks from 2019 onwards (average LTV of 45%, average spread of 350bps).
- As counter-cyclical lenders, 2020 was our busiest year since inception in 2013. We captured incredibly attractive deals at record returns and low LTVs.
- We have avoided the logistics sector since 2016 due to our belief that values were too high, ending in a 35% decline in logistics capital values in 2022. We have been active in the sector again from 2023 onwards.
- From 2021 onwards, due to our conviction in likely changes in the office sector, we engaged in a 24-month project to reduce and restructure our office exposure to ensure we were exposed to only best-in-class assets (from a location and ESG perspective).
- In 2021 we introduced margin ratchets for loans where borrowers make a meaningful improvement in the sustainability of the underlying secured assets.
These activities have ensured our portfolio of investments remains fully performing and that we can focus our attention on emerging opportunities.
Final thoughts
With the exception of poorer quality office assets, we believe most sectors have reached a landing in terms of valuation decline. We remain cautious, and believe some further softening is possible. Given our focus on best-in-class assets in sectors with the strongest fundamentals at sensible leverage, we expect 2024 to be a positive year for our clients.
For our sector views, see the table below.
| Sector | Outlook | Our view |
| Prime Office | Unsupportive | Negative outlook, will only consider best-in-class offices or those with clear transition plan to best-in-class. |
| Regional Office | Unsupportive | Negative outlook, will only consider best-in-class offices in big six cities or offices in these locations with a clear transition plan to best-in-class. |
| Industrial and Logistics | Supportive | Price correction has brought pricing closer to long-term historic trends and outlook remains positive. |
| Residential | Supportive/Neutral | Positive outlook for well-located assets in key cities due to supply demand fundamentals albeit ongoing risk to downside in terms of valuation. |
| Hotels | Neutral | Cautious outlook for the hotel market, however, we will continue to selectively consider highest-quality assets with strong sponsors and income protection at lower leverage points. |
| Retail | Neutral/Unsupportive | Polarised approach with supermarkets and well-let retail parks performing well. Secondary shopping centres and high street retail expected to continue to struggle. |
| Student Accommodation | Supportive | Selective approach favouring high quality assets in strong university towns and cities with undersupply. Preference for secured income from strong covenants. |
Source: abrdn January 2024
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