Demand for mezzanine financing among German real estate developers has grown in recent years as banks have lowered their LTV thresholds, creating a gap that is being filled by the private debt market. CrossLend spoke with Hubertus von Fircks, Managing Director of PEMA Invest Advisory GmbH, an investment management firm, about this structural funding gap, the firm’s focus on mid-cap developers, and how revitalising of existing stock can help reinvigorate cities and contribute to meeting environmental, social, and corporate governance (ESG) goals.

Roman Steigertahl: Please could you introduce PEMA Invest Advisory. What are your main areas of focus and specialisation?

Hubertus von Fircks: PEMA Invest Advisory (PIA) is an independent and owner-managed investment management firm focusing on the German-speaking real estate market. We advise Luxembourg-based funds and large institutional investors on individual mandates, especially in relation to allocating capital to real estate loans in these markets. These can be senior, junior, mezzanine, whole-loan, or bridge financing opportunities. The loans can be granted in almost any asset class over any project phase and are typically secured by a land charge. Thanks to our tailor-made alternative financing solutions, we can support real estate developers or investors as capital partners, even at short notice, and thus enable them to fully concentrate on their project. With every project, we strive for a long-term partnership.

Roman Steigertahl: Where do you see the opportunities in terms of the types of developers you typically work with and the project types?

Mr. von Fircks:

We see the Mittelstand (SME) sector as a sweet spot. This segment typically has mezzanine financing requirements that range between €10m-€ 50m per project, implying total investment costs ranging from €50-250m per project. The duration of projects and loans are typically 24-36 months. All our loans are secured by a ranking land charge or mortgage. Expected returns depend on each individual project and the risks associated with that project, but we are mainly aiming for double digit net returns.

Why do we focus on the mid-market segment? Outside of mid-caps, you can find smaller developers who are looking for smaller ticket sizes, but we see this segment as higher risk since these developers are often newer in the market. In addition, there is more competition between investors in this segment of the market since the smaller ticket size means it’s accessible to a much larger pool of potential investors.

At the other end of the spectrum are the much larger developers who can typically secure funding through the capital markets or from much larger debt funds. Here, while yields are typically lower, in our view, the risks seem to be similar to those in the mid market where we are active. One can question whether investors in these large projects are being sufficiently compensated for the risks, given the lower yields.

Another important point to mention is that in contrast to other European countries, which typically have only one important location (most often, the capital city), the real estate market in Germany is quite fragmented and consists of multiple top tier locations. In each location, you find these mid-size developers who are focused on their region, and who normally have good relations with local planning authorities and construction contractors. They normally also have the planning, project management, and technical know-how to see a development through to completion. They also have other advantages such as access to plots and projects. In addition, from an investor perspective, geographic breadth can result in good diversification in a portfolio.

Total alternative finance funding for European businesses, excluding UK
Source: European’s Commission Annual Report SME’s, IREBS

Roman Steigertahl: Looking at mezzanine lending, how has this segment developed in Germany with respect to private investors?

Mr. von Fircks: Before 2008 and the global financial crisis, there was basically no space for alternative financing in Germany. This is because senior banks were providing the entire capital stack to developers, with up to 85% of loan-to-valuation (LTV) or 95% of loan-to-cost (LTC). That has since changed quite dramatically in a number of ways. Most significantly, after the global financial crisis, the LTV limits for banks to lend on has come down, creating a long-term structural funding gap in the German real estate market, providing room for alternative (mezzanine) financing.

More specifically, banks have seen additional pressure on lending limits due to regulations such as Basel III or MiFID II. The increasing loan loss provisioning requirements that these regulations have brought forward limit loan-to-value ratios. This pressure is set to continue or increase.

However, it has still taken some time for the existing players – borrowers and especially banks – to adapt to the new normal, and accept alternative financiers and their collateral demands. Even though the number of debt funds has increased over the past few years, demand still far exceeds supply, so my view is that Germany still has some catching up to do on the supply side of non-bank debt solutions – this, of course, presents an opportunity for investors.

Specifically in relation to the Mittelstand sector that we’re focusing on, these local experts are not usually seeking equity partners. Instead, they are looking for lenders who know local peculiarities and customs in order to maintain operational control and maximise profits. They are also often sceptical of ‘foreign’ lenders. While this automatically excludes most London-based and most pan-European debt funds, it creates further opportunities for funds such as the ones we advise.

Regulatory Pressure, lower growth of banks vs growth of CRE market

Source: IREBS, FAP, IPF, Bulwiengesa, Preqin

Roman Steigertahl: Looking at deal flow, how much competition is there to access attractive deals? What does PEMA bring to the table?

Mr. von Fircks: Looking at the mid-cap segment where our focus lies, these firms have some specific needs. They are usually very well-managed companies, but they don’t have the capacity to write you a 20-page report every month. This segment has some quite particular needs, and it’s important to get close and stay close to these companies, which is our approach.

We have a good network of contacts and we are seen as a reliable partner. Our personal networks are our biggest asset in terms of deal flow; we have relationships with the majority of the most successful borrowers in their local markets, simply due to the length of time our team and our backers have been in the market. 75-80% of transactions come in via this network. If you have a relationship with an existing borrower, and they know that you can reliably deliver capital and that you stand by your word, it’s much easier to do a second or third transaction.

A second channel for deal flow is through structured processes, where investment banks, brokers, or lawyers are mandated by borrowers to structure their financing for them. We have standing relationships with these banks, brokers, and lawyers, meaning constant deal flow. Here, you have greater competition since they are presenting these opportunities to multiple investors. However, the brokers and bankers are also looking for transaction security, so as you work with them on multiple deals, the relationship deepens.

We created a third channel for deal flow with the help of an artificial intelligence company. They built a tool for us to use that scans for developments which are at the tender stage. These calls for tenders are publicly notified, and the AI tool screens local newspapers for tender announcements that match our preferred size, location, and other criteria, allowing us to narrow the opportunities down to developers we would like to work with. This is a novel approach which we are still in the process of refining to give our clients extra value.

Roman Steigertahl: Looking at the overall market, what trends do you see in commercial real estate (CRE)? What are some of the specific factors relevant to the German market that investors should consider?

Mr. von Fircks: We currently see three major trends in CRE. The first could probably be summarised under the buzzword ESG (environmental, social, and corporate governance). The real estate sector is currently responsible for 30% of global annual greenhouse gas emissions and it consumes around 40% of the world’s energy, according to the UN Environmental Programme. There is a strong impulse to build more energy efficient structures. However, there are drawbacks associated with greenfield developments, primarily the major emissions that come with such projects. The production of cement and steel are the main culprits. Consequently, refurbishing existing stock to improve environmental standards while also meeting future tenant and investor demand is the alternative solution – and perhaps the better one. Refurbishing existing stock in a sustainable manner requires flexible financing solutions.

The repositioning of assets is also a major theme in relation to economic changes. The landscapes of inner cities have to adjust to meet the drastically changed post-COVID environment in order to remain attractive to citizens and companies. These changes are most visible in the retail sector, which was in trouble well before 2020. Germany’s physical retail sector lost an additional 15% of its sales to online shopping over the past two and a half years, which will most probably never return. There is also a major transformation happening in the office sector. Here, creative solutions can unlock value in existing assets, such as transforming single tenant B-location office space into mixed-use assets. These activities can not only improve energy efficiency, they also serve communities by providing affordable housing or spaces designated for social infrastructure such as kindergartens or community spaces.

Secondly, we also see a widening of the structural funding gap, as discussed earlier. The implementation of Basel IV will further restrict the lending capacity of banks. The German banking market is also highly fragmented with over 1,800 banks, most of them acting only in their local municipality. Since 2020, these banks have become even more restrictive and have significantly reduced their lending, lowered loan-to-value ratios, and increased their margins.

In addition, in recent years, we have seen increasing consolidation in the senior banking segment, namely amid Landesbanken, Volksbanken, and Sparkassen. Overall, this leads to a significant widening of the funding gap and more demand for mezzanine and other financing solutions.

Finally, we are also seeing a sharp rise in the demand for whole loans. For property developers, the available capital from senior financing is often insufficient. This is mainly due to lending restrictions that banks are increasingly exposed to. Especially in the acquisition phase, real estate investors usually have to act quickly to obtain exclusivity for off-market properties. That means they need financing commitments from credit institutions within four to eight weeks.

However, due to lengthy due diligence and reconciliation processes in the traditional financing structure of senior and junior loans, it usually takes investors at least ten to 15 weeks to finance a project or property. Delays due to long coordination and decision making processes can extend this timeframe, often leading to increasing costs and missed opportunities for investors as well as for financing institutions. Traditional banks are also usually limited in their flexibility and investors often cannot rely on soft commitments in transactions with such time pressure. Here is an opportunity for alternative lenders offering whole-loan structures on competitive and flexible terms to gain a competitive advantage and build close relationships with prime borrowers.

European non-bank debt providers – supply shortage in Germany

Roman Steigertahl: Construction is obviously a complex industry, and there are almost limitless issues that can arise on a site or affect a project. Can you please walk us through your approach to due diligence and highlight some of your expertise in this area?

Mr. von Fircks: We look at risk using a three-dimensional approach. We segment these out into several main areas.

First, we have borrower risk – for example, you can have a good project that is poorly managed. Another scenario is a good project that is well-managed, but where the borrower has another project – that you are not associated with – that is faring poorly, implying a credit risk around the borrower, which could affect your project. The track record of the borrower plays a big role in our risk processes. We look at their track record of delivery, and aspects such as continuity of management. So, we usually begin by conducting an asset or property inspection and meeting and speaking with the potential borrower to learn about the property’s background and how the property fits into the specific micro-location. This mostly speaks for itself. Many of these companies are family or manager owned, so there is a high incentive not to take on excessive risk.

Secondly, we look at market risk. Of course, you are financing a development that will be sold in the future, so you have to look at how rents are developing, sales prices, and the different asset classes within the real estate market. For example, had you financed a hotel project in the lead-up to COVID-19, you would have seen a quite unexpected market-wide impact on hospitality. Similarly, today, there are some questions around the outlook for office space, given the uncertainty about the future of workplaces, whether workers will go back 100% to offices or whether a hybrid model will develop. Our internal due diligence includes: an analysis of the economics of the business plan, a technical analysis to implement the business plan, as well as the validation of construction costs. We also carry out an analysis of the potential borrower’s creditworthiness, a legal review, and an environmental review, if necessary. In addition, a detailed cash flow model is created for each project or property.

The third area is project-specific technical risks. Every project is different and the risks depend on the singularity of an individual project. It’s not just about the engineering and technical feasibility – there are also risks across the chain of the project, such as whether cost security is in place for payments to construction contractors. In the present environment, there are issues around the availability of contractors, delays that can result in cost increases, and also issues on the raw material side. Planning is another aspect – if a developer has to wait for final planning confirmation from the local authorities, this can result in an increase in costs. Therefore, we also seek the opinion of recognized external service providers (valuers, lawyers, project controllers) for each investment. Their findings are used to complement or confirm our own analysis of the project, the market, and legal factors.

But even if everything looks under control with respect to these issues, it’s a construction site and there are a million additional things that can go wrong. You have to monitor these quite closely. Here, you need to have a good technical understanding of the market and of the sites’ processes. What we see is that most other debt funds and banks are looking at projects mainly from a financing and investing point of view, and they often take a check-box approach to the technical issues at the end of their due diligence, such as by outsourcing this to an external consultant. Our approach is to take these technical risks very seriously; it’s something that we consider from day one. To this end, we have a technical team that is included in the whole due diligence process from the very beginning. These are experts with development and technical backgrounds – they are close to the market – and they examine aspects such as construction costs, the track record of the borrower, and overall technical feasibility. They have knowledge of the present situation around construction and material costs, and they can estimate the specific costs per square metre in a certain region. They also have knowledge of the planning process timelines in the different states.

Once we’ve written a loan, we have a rigorous loan monitoring system, encompassing a combination of in-person site visits with the technical team, as well as first hand discussions with the borrower and the senior bank. This ensures we remain very close to each project, and we can foresee if an adverse situation is likely to arise. In these cases, we look to develop a solution together with the borrower, or as a last resort, we actually step in.

Roman Steigertahl: Talking about unwanted outcomes – what processes would you go through in case a borrower is no longer able to service their loan?

Mr. von Fircks: Obviously through our due diligence process, we put a heavy focus on preventing such an outcome, such as excluding all the technical risks ahead of paying out the loan; The funds / mandates advised by us invest only in high quality borrowers with extensive track records that have delivered institutional-quality real estate products in the past.

We solely focus on high quality properties in prime locations which therefore have high levels of liquidity throughout market cycles. Our robust underwriting and due diligence process, alongside our position in the capital stack between our loans, can subsume significant corrections in rent levels and exit values (c. 15%) before returns and principal are at risk.

The second part of this is to structure the strongest possible security package for our loans. As I previously mentioned, all our loans, plus the outstanding interest, are secured by a ranking land charge. In addition to that, we have all other standard securities, such as a call option on the SPV, a share pledge on the SPV, intercreditor agreements, and so forth.

Looking at the loans we can grant, we rely on an external valuation. On that value, we will go up to 85% maximum, so we build in a minimum risk value of 15-20%, meaning that the value of the property could decline by that amount before our principal is at risk. 15% has a historical relevance; it was the maximum decrease in value of institutional prime assets during the global financial crisis.

We have a rigorous loan monitoring system, including desktop stress tests that can be carried out on a monthly basis, allowing us to anticipate the impact of adverse events like changes in rents or yields. We combine that with on-site visits from our technical team to ensure that the project is on target.

We always have an intercreditor agreement with the bank, outlining how mezzanine and senior lenders will work together in case of a covenant breach or default (i.e. healing rights). Most breaches (and defaults) are healed through discussions with the borrower i.e. the borrower pays its obligations without the need for any asset sales.

It’s important to mention that Germany is quite a lender-friendly market. The strongest possible collateral you can have is the ranking land charge. If a borrower fails to heal a breach expeditiously, the senior lender has the authority to sell the asset in the open market. Mezzanine lenders with land charge are protected, as an asset sale must achieve a price high enough to cover the mezzanine loan and at least the market value of the property. Mezzanine lenders with call-option on SPV shares are protected as they can quickly take control of the SPV and can heal any breach. In the rare case in which a default is not remedied, senior and mezzanine lenders can initiate a foreclosure process. In the case of a foreclosure, a mezzanine lender has the right to acquire the asset if the highest market offer does not pay back the mezzanine loan. Meanwhile, a senior lender can sell the asset through an auction process. Nevertheless, foreclosures and auctions are rarely used for institutional real estate and are more common for individual apartments. Auction processes have restrictions due to the inherent protections in place, namely that any lender can stop the auction if highest bid is below 70% of market value; the first auction will be stopped if the highest bid is below 50% of market value; the mezzanine lender has the right to bid, and finally, the mezzanine lender is entitled to purchase the senior loan.

Roman Steigertahl: What role do you see for technology and innovation in the funds and investing space more generally, and how can this deliver value to investors?

Mr. von Fircks:

We believe that technology can be a huge driver for value creation. This is why we emphasise a firm culture which favours data-driven, independent, and evidence-based thinking.

From the very beginning, we are consistently trying to streamline and automate our processes in deal origination, due diligence, risk management, and reporting, and thus we are able to streamline, while simultaneously improving our investment process, ensuring high deal certainty and saving time and costs both for our investors and our borrowers.